EMD Relative weekly notes
Week Ending September 9, 2016
Developed market central bank support disappointed mildly this week, leading to softer conditions in virtually all financial markets including emerging markets (EM). The European Central Bank (ECB) kept the status quo and did not explicitly state that QE bond purchases would extend beyond next March. However, their “body language” indicated such an announcement seems to be just a matter of time. US Federal Reserve (Fed) speakers managed to nudge up rate hike probabilities, which had fallen dramatically in the wake of softer economic data.
For EM, specifically, we have officially had the strongest 10-week stretch of inflows into mutual funds in the history of the asset class. The global search for yield has found EM, if there were any doubt about that happening. With developed yields at historical lows, it will take an awful lot of risk aversion to threaten a continued thirst for income over a medium-term time horizon.
Over a shorter time frame, the primary risk for investors seems to be the Fed. It's not so much nudging rates up that is the problem--if that nudging takes place at a time of unequivocal, strong economic growth. The problem for the market is when the Fed's laying the groundwork for a rate hike comes at a time when the data is at best ambiguous. So this week we had rising probabilities of rate hikes coupled with a near-term background of softer data--not a great combination. A reasonable investor may, therefore, be concerned that the Fed's dogmatism over an endlessly discussed hike could result in poorer economic prospects coupled with a spike in market volatility.
The chart below shows the Citi surprise economic index for the US, and its sharply descending line tells the tale. In addition to this, the Atlanta Fed's forecast for this quarter's growth, which a few weeks ago stood at 3.8%, is now 3.3% and falling. So we, along with everyone else, will see how markets calibrate the risks of the Fed going into this month's meeting with great focus.
Source: Bloomberg, Citi US Economic Surprise Index; data as of September 9, 2016.
For EM, the volatility will be felt across the opportunity set, but investors should be reminded that spreads to treasuries are not particularly stretched, in our view--investment grade sovereign bonds are only about 10 basis points below a five-year average. Currencies, however, will likely be more volatile as EM FX volatility is well below historical averages and has fallen sharply. With that backdrop and being mindful of the bigger picture of necessary yield-reaching for global fixed income investors, shedding EM dollar exposure seems unwarranted, in our view. A significant reliance on currency appreciation for gains in EM may also be unwarranted until more clarity from the Fed emerges. But a broader perspective suggests to us that all asset classes will be forced to adjust, and EM yields should provide a significant buffer—while in larger developed markets, that buffer is small to completely non-existent.