EMD Relative weekly notes
Week Ending April 22, 2016
The question most asked of us this week was: "What can derail the recovery in emerging market assets?"
We view the underlying impetus behind that question (as we interpret it) as a positive ─ that many people have not participated fully in the rally, and are wondering if it is too late to commit new capital. Anecdotally, we see no signs of a broad resurgence of institutional interest in the asset class, and discussions with traders globally at Schroders suggest few indications of aggressive positioning in emerging market currencies. But make no mistake: for US dollar-denominated emerging market debt, we feel the best part of the rally is behind us, barring a real historical anomaly. For currencies, the picture is less certain given the historical plunge in nominal currencies over an extended period that preceded the current rally.
On the US dollar side, spreads for investment grade sovereign debt have shrunk by roughly 100 basis points since the wides of February 11th ─ a remarkably swift fall, but a review of history after other stressed market episodes reveals that it is hardly unprecedented in this asset class. Current credit spreads of roughly 220 basis points are nearly at the historical average of around 210 basis points. As rallies from stratospheric levels matured after the financial crisis of 2008 and the European crisis of 2011, we spent multiple months below the historical averages, dipping as low as 150 basis points in late 2012. And there is an argument to be made that in a world with nearly $8 trillion of sovereign debt trading at negative interest rates, tighter spreads are warranted in periods of market calm. We concede this point, but risk and reward in this part of the asset class, which includes both sovereign and corporate debt, has become far more balanced.
Currency valuations are far more problematic given the multiple considerations of real exchange rates, local yields, correlations with other assets, etc. Year-to-date returns from currency movements alone are 6.4% which, in the context of a nearly 50% fall in nominal currencies from May of 2013 to the start of this year does not seem excessive. Furthermore, the return of inflows into the asset class creates its own reality of better fundamentals, which gives central banks more degrees of freedom to lower rates and improve growth prospects that lowers yields in a virtuous cycle. However, as some parts of the opportunity set are more highly correlated with the Euro, other parts with oil, and yet another from developments in China, this means some discrimination in exposure remains key even if future return prospects from a starting point of today seem somewhat more robust.
In short, while we would like to tout our own performance YTD as indicative of happy days in emerging market debt, in fact our job gets harder from here. We are approaching US dollar exposure with a more critical eye while becoming circumspect of wide outperformers in the local currency space.
This view is quite different from guessing that the good times are mostly over, causing us to raise cash. As in other historical recoveries, as long as the fundamental drivers (such as permissive global monetary policy, oil price recovery and China stability) remain in place, attractive returns are still available in emerging markets. We are simply shifting from an environment of spread compression to a setting where steady prices lead to attractive income returns relative to other asset classes, in our opinion.
The lessons for investors considering new capital allocations in this evolving part of the emerging market cycle are to invest with reasonably strong overall credit quality, disciplined US dollar exposures, and currency exposures tilted towards countries that are most positively affected by the liquidity dynamics currently in play.