Co-Head of Emerging Markets Debt Relative
Jim Barrineau, our emerging market debt specialist, takes a second look at the three key drivers of emerging debt he discussed on 19 January and links them to the recent rise in investors’ readiness to take more risks.
Risk appetite increased rather suddenly last week and emerging market (EM) debt was a clear beneficiary.
Given that the asset class was at the epicentre of the sell-off that kicked off the new year, it should disproportionately benefit from the rebound, if it is sustained. And we would argue it should be sustained, propelled by improvements in three key macro market drivers:
Stability in the renminbi seems to equal reduced tail risks emanating from China.
January is appearing more and more like the last week of August 2015 – a swift, but not necessarily large, move down in the currency that triggered a wave of tail risk fears which were only dissipated once the currency was allowed to appreciate slightly from its new, and lower, levels.
The rebound in risk appetite in general and EM currencies in particular this time can be traced to the flat to slight appreciation in the renminbi that began on January 7, but which was preceded by a depreciation of over 1.5% the previous week. That sharp move meant global risk-off.
The recovery only started as the market gained confidence that the depreciation would be kept under control.
What may have been somewhat different this time is that a more outspoken cadre of Chinese policymakers conceded that equity interventions had been botched and currency changes had been poorly communicated.
So there is room for some tentative hope that a lesson has been learned.
The direction of the currency in the medium-term will almost certainly be down, but the pace of that change will hopefully be managed with more care.
EM currencies are particularly sensitive to this: from the last week in December to the January bottom on the 20th, the local currency index fell 4.77%. The subsequent recovery by the end of last week was 3.17%.
So the slightly negative monthly return likely to be recorded in no way captures the dynamics at play.
Continued stability is quite encouraging for the risk-reward balance of an asset class that delivered its worst-ever historical returns last year, when investors lost close to 15%.
We would set aside completely the rumours that there might be some type of OPEC deal with Russia to curb production.
Even so, with oil prices in the low $30s, the highest probability still seems to point towards higher prices over an undetermined timeframe, but probably measured in months.
The carnage among producers and the subsequent cutbacks in spending continues with a near-daily drumbeat.
Global demand does not seem to be falling materially. Indeed, there has already been a noticeable rebound in the price from around $26 to roughly $32.
For emerging markets, oil (and to a lesser extent other commodities) has a particularly significant impact on sentiment and liquidity.
So we expect any continued stabilisation or moderate rise in prices to provide general support for emerging markets.
Developed market monetary policy was particularly supportive for risk assets last week.
The market now awaits with baited breath the further easing from the European Central Bank hinted at by its President, Mario Draghi.
But the star of the week was the Bank of Japan’s (BoJ) surprise move towards negative interest rates.
They should push money towards higher-yielding assets, with dollar-based emerging markets a specific beneficiary.
As long as the US Federal Reserve (Fed) validates – or at least does not attempt to discount – the market’s pricing out of the central bank’s previously telegraphed series of rate hikes throughout the year, we would call that supportive.
Last week’s Fed meeting and the slightly dovish tilt of its subsequent statement seemed to do just that.
The attached chart is of the Citi surprise index for US economic data, which measures how much the actual data beats or misses estimates.
The recent trend lower suggests that forecasts are being regularly missed, further reinforcing our belief that multiple rate hikes will be challenging, something that is reflected in Treasury market yields.
Against this stable risk environment, investors seeking interest rate risk will favour markets with high spreads over Treasuries – and EM debt has among the highest.
Such flows should be further encouraged by the BoJ move which, as we suggested, should particularly favour dollar-based emerging markets.
Last week began with EM debt yields that were the highest we have seen since the end of the global financial crisis.
The week ended with investment grade sovereign spreads at a level of 300 basis points versus an historical average of 200.
A compression of EM yields toward historical averages, coupled with the existing yield of 6.7%, would undoubtedly provide one of the highest returns available in global fixed income—assuming key drivers continue to be benign.
So we are encouraged by the implications of recent developments, which seem to favour the battered emerging markets.
Euphoria is certainly not called for—growth fundamentals overall seem steady, while any continuing sore spots as a result of truly stressed situations on the sovereign side seem few.
Any corporate stresses seem well telegraphed and largely confined to the fallout from commodities and energy.
But the yield levels on EM debt seem more than adequate compensation for the risks, with the potential for substantial capital gains to boot.