EMD Relative weekly notes
Week Ending September 23, 2016
On a macro basis, this past week was about the reduction of market uncertainty, which we think will be supportive for emerging market debt assets going forward.
The Fed suggested that while they may hike rates in December, the outlook for an extended rate hiking cycle into 2017 has softened. The DXY Index, an index measuring US dollar strength against a trade weighted basket of currencies, slid a half percent from Wednesday as the week ended--an EM positive factor. After a shaky start the local currency index is up just over 2.5% for the month and the Fed meeting is likely to limit any sharp reversal there.
While the Fed was perhaps more supportive for EM FX, we view the Bank of Japan (BOJ) meeting this week as supportive for dollar assets. Trotting out a new tool of managing the yield curve is both positive for Japanese banks but also structurally positive for reducing bond volatility that could potentially be transmitted to other markets. Given that the Japanese 10-year rate will be anchored at 0%, the reduction of volatility plus the certainty that the global search for yield will continue is an unambiguous positive for those assets with the most yield on offer--EMD. The rise in the value of the yen after the BOJ meeting suggests additional easing measures are likely since there can be no credibility on inflation targets in the context of yen appreciation. EM is the tail of the global volatility spectrum, where history shows volatility originating in developed markets is felt across EM in exaggerated fashion, so the BOJ action should not be under-estimated for the asset class.
Even if investors accept that key drivers remain supportive, it is human nature to pick out a specified period of past performance--especially when that performance has been very positive--and wonder whether it can continue in a positive vein. Year-to-date the two dollar based sub-components of the EM asset class--sovereign and corporates--are up about 13% on average, while local assets are up nearly 18%. Is that an extended market? Our answer is it's difficult to be sure: in the same period long bonds in the UK and Germany are up about 18%, in the US about 10% and in Japan about 23%.
We find investors both fail to put emerging market assets into this proper context, and secondly do not tend to think about emerging markets in an appropriate context relative to the new age of central bank policy-making that we see unfolding month after month. If you believe that central banks are highly unlikely to take their collective feet decisively off the QE-era gas pedal over the coming 12-18 months, then it’s logical to expect that the most likely beneficiary will be the asset class offering the most income in a world starved for that characteristic.
- Fixed Income