EMD Relative weekly notes
Week Ending June 24, 2016
We won't re-cap the Brexit happenings; instead we will simply focus on the aftermath in emerging markets (EM). In the near term, risk is elevated and caution is appropriate. One part of the opportunity set—FX risk—becomes decidedly less attractive on a short-term time horizon, while dollar bonds, especially sovereigns, are worth holding through the turmoil. Here is the basis for our belief:
The chart below shows the US dollar index for the month of June. The sharp drop early in the month represents the post-soft jobs number fall, followed by the stability which allowed the EM local currency index to produce a 4% return for the month prior to Friday. Note that the sharp rise on Friday merely represents a re-tracement of the total June fall. Therefore, it is logical to believe that the ongoing uncertainty over Brexit fallout could produce a more pronounced bout of dollar strength. That would make emerging market currency exposures in general less attractive.
Source: Bloomberg, DXY Index; data as of June 24, 2016
However, the raw material for a softer dollar over a longer time horizon has also been put into place: according to the Fed Funds futures market the Fed has been priced out of the market in terms of rate rises through 2016. Of course, we cannot forecast how long the Brexit fallout lasts, but if history is any guide when an equilibrium of market pricing with the new set of fundamental risks is achieved, the prospects for an extended period of developed market central bank policy convergence would mean a soft-to-stable dollar and an attractive EM FX environment.
Dollar bonds in emerging markets have initially been well behaved, with modest price falls relative to most other global assets. We are not much surprised at that outcome, given their attractive yields and relatively high credit quality in aggregate--indeed higher-rated sovereigns and corporates have done very well. We believe, however, that spreads to US treasuries are likely to rise over the near term, but that would be an unfortunate metric by which to decide to shed this risk. Yields remain extremely attractive to the global fixed income opportunity set—much more so today than yesterday. We feel markets will eventually re-discover this as central banks continue to suppress other income opportunities. Because we cannot time markets any better than any other human, we conclude that holding our exposures here is very reasonable considering these factors, and we believe will result in an attractive return over the rest of this year.