Market Views: Fixed Income
EMD Relative weekly notes
Week Ending February 12, 2016
One key tenet of behavioral finance is that markets tend to overprice the probability of worst case outcomes, so the fear that markets are facing the end of the major central banks’ collective ability to create inflation (at least in asset prices) seems premature. Eventually that fear, should it continue, would invite a response meant to disprove the notion, and that would occur in a context of prices stretched far to the downside. We may not be there yet but eventually that consideration should slow selling.
A corollary to this is that markets are grappling with a slow growth outcome in developed markets. A slow growth world seems a near sure thing, and part of the commodity correction is the story of producers adjusting to such. One of the most interesting facets of this to us is that emerging markets (EM) have been pricing in that slower growth world since mid-2013. Only now are developed markets (DM) responding. We have witnessed a steady rise in EM fears as measured by aggregate credit default swap spreads and FX volatility over the past 30 months, while developed market bond and equity volatility barely moved. So if one concludes that markets are grappling with persistent growth disappointments, those parts of the asset spectrum that have already priced in that outcome should be most attractive to investors. EM outperforming DM seems quite plausible—if not probable--under this thesis, in our view.
Want a single price to watch to tell you prospects for EM? Watch the US dollar. The attached chart shows the stratospheric rise, and current sharp correction, of the DXY index since the taper tantrum. The Fed’s careful preparation to raise rates over these past 32 months has arguably brought on this market turmoil—and soaring dollar—so if that possibility now has to be unwound, that would be a significant positive for EM. So far in February, despite the headlines noting blood in the streets for US equities, the EM local currency index has outperformed the dollar space by about 1%—and produced a near-2% positive return. Asian and European currencies more than made up for Latin American softness. Coming after three consecutive years of negative returns and a return last year that was the historically worst by an astonishing 600 basis points, it’s easy to see how powerful a reversal could potentially be.