Co-Head of Emerging Markets Debt Relative
One of the things about the Fed’s long-awaited rate hike this week that makes us moderately more optimistic is the clearer definition for the divergence between developed market central banks. It is no secret that this divergence has led to a significantly stronger dollar that weakened emerging market currencies and led to liquidity outflows rivaling those of the financial crisis of 2008. Pre-Fed, the ECB defined a path forward of continued, but less than expected, QE as growth stabilizes on the continent. Then the Fed laid out a path that includes the expected moderate rate of hiking over the course of the next two years. If the Fed has erred in that forecast—and their ability at prediction is at least as poor as the market’s—we believe it will likely be on the side of fewer rate cuts. Evidently the treasury market concurs, as the curve has flattened significantly after the announcement on Wednesday--not a sign of confidence in accelerating growth.
We don’t believe the impact of that clearer path will be immediately evident in asset pricing. Market liquidity will be nearly non-existent over the coming two weeks and new year allocations will begin to sort out the level of confidence in the Fed’s forecasted path. The key point is that because that path has now become the centering point for market expectations, softer growth that lowers the expected hiking cycle should dent the strong dollar story, which would be a great aid to sentiment in emerging markets as currencies would likely steady while outflows dwindle.
The other central bank that matters for emerging market sentiment is, of course, China’s. We continue to be surprised at the equanimity with which the market has taken a depreciating yuan, which is down by about 2.5% in six weeks and seems to incrementally weaken daily. Continued acceptance of this without a resumption of market fears would allow the Chinese greater policy flexibility and increase the odds that growth continues to stabilize. We would note that solid growth numbers were released this week, only to get buried under Fed headlines.
The market’s reaction to the Fed also seems to suggest that developed market bond yields could remain low for longer, as if the treasury curve does not buy the robust growth story. That will help force investors to continue to access EM dollar yields. Sovereign investment grade spreads remain near five year highs, and the absolute yield of high yield sovereigns is 8.5%, so even if investors are concerned about corporate default rates, more liquid opportunities at historically generous yields are widely available. None of our measured optimism is dependent upon wildly bullish resumptions of risk appetite. We accept as a baseline proposition that we will be in a low-returning world for nearly all assets, including developed equities—which makes potential returns above 6% with steady EM bond prices an attractive proposition that we believe should limit downside surprises from a returns perspective.
This is our final blog post for 2015—a terrible year for our asset class by any measure, and one that will have seen the worst year on record for fund flows. Every measure of EM sentiment is at stretched levels that suggest a systemic crisis, yet at the end of the day EM growth should still best that of developed countries--and dollar returns were positive! Given that and the income generation available to those who can afford to wait for a turn in sentiment, we will usher in the next year thinking emerging market return surprises stand poised to be more positive than nearly any other option in global fixed income.