Co-Head of Emerging Markets Debt Relative
Last week saw a turn in the cycle that has driven emerging markets for the last two years. Jim Barrineau, our emerging market (EM) debt specialist, says one of the necessary conditions for a better background for EM debt is now in place.
The accumulated weight of negative US economic data, and the market’s pricing out of rate hikes by the Federal Reserve (Fed), finally hit the US dollar last week: on Wednesday (the 3rd) the currency had its worst day in five years.
While growth fears may weigh on equity investors, a weaker dollar is positive for emerging market debt investors. A continued break in its strength would mark a change in a trend that has, since early 2014, decimated emerging market currencies.
We put together the attached chart that shows the dollar index, the Mexican peso (green, with a rising line indicating depreciation) and the price of oil (purple, inverted).
The correlation of these assets neatly tells the tale of emerging markets over the past two years: the withdrawal of quantitative easing by the Fed, along with its promise to move towards “normal” interest rates, drove the dollar sharply higher. At the same time, the price of oil went in the opposite direction (although, of course, there were other drivers too) while EM currencies, represented here by the most widely traded, the Mexican peso, went sharply lower.
That correlation seems to have broken down with the more recent weak economic data, which is now expected to stay the Fed’s hand in raising rates and help reduce the divergence in developed economy monetary policy.
This change of direction should, at the minimum, give pause for thought to the substantial number of market participants who have bet that US growth outpacing the rest of the world would mean an ever-strengthening dollar and ever-widening interest rate differentials.
In reality, growth prospects in the US seem to be about on a par with those of Europe, and trending lower, while Europe’s are stable. So the weight of the market getting on-side to that reality could be substantial.
The alternative argument is that, even with weaker US growth, the dollar’s safe-haven status remains intact. That is certainly a possibility, but we would distinguish between a slower growth trajectory that leaves US interest rates on hold, which is what seems to unfolding, and an outright recession that causes systemic stress, and might require a monetary response.
The latter thesis remains untested and would obviously require a re-calibration of the outlook based on the impact of a softer dollar on asset markets.
One encouraging signal so far is that in recent days the price of oil has remained near its near-term highs of about $34, while equity markets globally have remained soft, which represents a break in the two markets’ recent correlation. It would be difficult to envisage that happening if investors expected further financial stress ahead.
A somewhat softer dollar would work to put a floor under commodity prices, and spur more liquidity flows into emerging markets.
Stable to somewhat appreciating emerging currencies would curb rate hiking cycles in those countries dealing with the inflation pass-through of deeply depreciated currencies, leading to marginally better growth. So the basis of a positive cycle is there, even if it is too early to suggest that it will take hold. What we can say, however, is that a necessary (if not sufficient) ingredient has appeared.
For dollar emerging market debt, it’s a bit more straightforward: the weaker growth story is leading to a flatter yield curve which makes dollar spreads over US Treasuries that much more appealing.
Interest rate spreads on investment grade sovereign bonds remain stuck at around 300 basis points, so with an historical average of just over 200 basis points, substantial value remains in taking some interest rate risk on emerging market dollar debt in the current context of softer US growth.