EMD Relative weekly notes

Week Ending January 6, 2017



James Barrineau
Head of Global EMD Strategy

Markets are off to a quick start this year. EMD sovereign debt is up in the first four trading days by 52 basis points, corporates by 27, and local currency by 38. The "pause" in the reflation trade as the US dollar has steadied and long duration US treasury yields have declined has been a positive tailwind for EMD.

The global economic data continues to support the underlying thesis of reflation, however, as US wage growth is the highest since 2009, fourth quarter US GDP is forecast to be well above 2%, and global PMIs are rising in a well coordinated pattern across major economic regions. The post US election rise in risk asset prices generally seems to have priced in those data points.

So the question is whether we will actually get the next step in reflation: fiscal stimulus in the US and perhaps less reliance on monetary policy in Europe that would potentially lead to higher commodity prices, higher wages, and higher prices.

An unambiguous application of additional fiscal stimulus at this point in the economic cycle would probably hurt EM assets, as dollar assets would fall with treasury prices, and currencies would fall with a stronger dollar--even if growth benefits from the tailwind of stronger developed economies. Whether that develops is still pure speculation at this point.

With that framework, we still find good opportunities in non-investment grade debt across the asset class, but primarily in the sovereign space. Such debt reduces interest rate risk and raises credit risk--perfectly consistent with the reflation theme. In local currency we find fewer compelling opportunities for now. Rates compressed significantly in most countries last year, and the impetus for further compression seems limited if global developed bond yields rise and EM central banks at the same time have no scope to lower domestic rates. That leaves investors more dependent on currency gains for pursuing attractive total returns, a somewhat risky proposition with a strong dollar and the Fed in a slow hiking cycle, even aside from a stronger reflation regime.

Should US policy fail to meet market expectations for additional stimulus, local currency investing would likely be the best opportunity if the dollar reacted by losing steam or stabilizing. A higher conviction level, though, is needed to commit to more currency exposure given the much higher volatility in that space.

Thus we think that continued opportunities in EMD are being manifested, but the next few weeks will go a long way in determining an optimal rotation between them as the market sorts through the reflation story.

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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.


James Barrineau
Head of Global EMD Strategy


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