EMD Relative weekly notes
Week Ending May 13, 2016
Most of the market discussion this month has been about the seasonal weakness and risk avoidance appropriate for May. For emerging market US dollar-denominated debt, however, price moves have been rather muted. Credit spreads to US treasuries widened by about 15 basis points to start the month, but have recovered about half that amount as of this writing. Local currency returns have been close to negative 3%, but after a three month gain of 13% a pullback of that magnitude is hard to complain about. Generally speaking, some periods of market movements represent noise, and some represent signal—this current situation seems to be the former rather than the latter.
We have seen no significant change in the three positive themes for emerging markets (“EM”) we identified to start the year—Chinese yuan (CNY) stability, oil stability, and developed market central bank support. Of course, we are not complacent about any of these conditions continuing forever. In China, some questions have been raised about a slowdown in credit provisioning leading to a slowdown in GDP growth. After rising rapidly in Q1, there are early signs that credit growth is slowing, but only very incrementally. Any impact on GDP growth is likely to be evident only months down the road. For us, the news on oil is improving as supply disruptions in Libya and Nigeria are being matched by a fall in US production, where production is now at September 2014 levels. At the same time, the IEA raised global oil demand growth this past week. It seems clear that the supply overhang is well on its way to correcting; though, as always, price movements in the near term are anyone's guess. Continued exposure to EM oil correlated assets without meaningful impairment risk still seems to be an attractive option. Lastly, we see no significant change on the central bank front, though it is clear the market is hyper-sensitive to this issue. A better-than-expected retail sales number in the US led to a spike in the US dollar on Friday, illustrating this sensitivity. A broader view indicates that a lot more evidence is needed to suggest that growth will alter the permissive framework in monetary policy. The chart below shows the Citi surprise index for economic releases in the US, and its steady decline suggests that probabilities for a near-term change seem low.
Source: Citi U.S. Economic Surprise index, Bloomberg; data as of May 13, 2016
It is becoming more notable that policy frameworks in major emerging market countries continue to improve in aggregate. Indonesia remains a good growth story with policy flexibility to continue improving. Russian growth clearly seems to be bottoming, and we expect a rate-hiking cycle to commence shortly. The inability to issue new debt due to economic sanctions creates an enduring positive technical. Argentina's policy turnaround has been well publicized. In Brazil, a new president took office following the long running impeachment drama, and that development promises better governance in one of the largest countries in the asset class. A new finance minister has laid out a program that essentially represents what could be a market wish list for changes. For now, only Turkey seems to present a probability of policy degradation as the current president consolidates power. The net effect of these changes should show EM growth improving this year compared to last, and set to improve next year compared to this one.
A common question we have fielded following the sharp rally since mid-February is whether we would recommend new allocations to this asset class right now. We believe the answer continues to be yes. The factors listed above are one reason, but perhaps the most powerful is the simple lack of liquid income-producing alternatives available for investors, whether institutional or retail. This week, 10-year German bunds hit a yield of 11 basis points, while 30 year treasuries in the US—as one of the last bastions of income left in the developed government world—have fallen in yield from 2.75% in late April to 2.56% today. Those yields offer no room for any surprise that might move the price of the bond lower and wipe out years of potential income. We expect that the yield advantage of emerging markets will continue to become eroded if for no other reason than the dearth of income opportunities globally. Therefore, the bar for suggesting an investor should reduce or refuse allocations to this asset class should be set appropriately high in that framework, and the small market jitters so far in May don't come anywhere near that level in our view.