Market Views: Fixed Income

EMD Relative weekly notes

Week Ending February 26, 2016


James Barrineau

James Barrineau

Co-Head of Emerging Markets Debt Relative

Perhaps the most meaningful data point an investor can take out of the month of February is that it will almost certainly mark the second consecutive month of a positive return for the local currency index—the first time we have seen that since the first half of 2014. What happened next that year? The Fed started preparing the market for rate hikes, which tightened financial conditions and caused a large spike in the dollar and about a 23% fall in the local currency EM index from that point until now. Assuming that self-created tightening of financial conditions does not lead to any significant actual tightening, the opportunity set for emerging markets should present a more balanced outcome between credit risk, interest rate risk, and currency risk—with the latter having the largest potential upside given its historic fall from grace. Monitoring the conditions that would produce that outcome, and capturing that market beta in the best possible way, is our complete focus.

It remains our belief that the local currency story at least at present is dominated by the dollar. From the start of February to February 11 the dollar index fell 4%, and since then has risen about 2.7%, driven by “Brexit” fears which have hurt both the Pound and the Euro. Clearly, a resurgence of dollar strength could help derail a more positive story for EM currencies.

However, another key factor for emerging market sentiment and reality—the price of oil—has not been correlated to the most recent move in the dollar, and WTI has risen just under $4 from a near-term low on February 11. That seems to signal that the dollar strength is probably viewed by the market as less of a structural move higher driven by better dollar fundamentals, and more of a temporary spike driven by fears generated by the other side of the currency coin. That remains a thesis in need of additional supporting data at this point.

Nevertheless, higher oil prices are a positive for the asset class and will likely encourage liquidity into the asset class if history is any guide. Completely discounting the ups and downs of the stories that oil producers may or may not agree to materially limit production gains, falling US rig counts and what seems like the endgame for many stressed smaller producers globally appear to be giving investors comfort—the heavily consensus view of a slow grind up to a $45-$50 price by the end of the year is at least feasible. If it materializes, we would view that as a significant positive for the asset class.

Aside from the recovery in the local currency index, February has also seen a move into positive territory for dollar EM. Since the February 11 market low across all asset classes, investment grade sovereign spreads have compressed by a fat 36 basis points—yet remain about 75 basis points above their historical average.