Market Views: Fixed Income
EMD Relative weekly notes
Emerging markets are in full throttle mode. The local currency index, after a historically unprecedented fall, is up 9% YTD. Dollar sovereign debt is up 4.5%—about four times the return for the entirety of 2015. Spreads to US treasuries have fallen 100 basis points since the highs of February 11th. While other asset markets have recovered nicely from that date, emerging markets have by comparison skyrocketed. How did this happen, and have we realized the best of the returns already?
Our three investment theses for emerging markets—CNY stability, oil stability and supportive developed market central banks—have been in place since late January following the CNY wobble of early January. Over that same time frame, the price of Brent crude has risen $15, or 55%. These moves show that the stabilizing factors for the asset class actually began to fall into place before asset prices began to recognize that was the case. After the Fed meeting this week and the significantly dovish message, along with continued oil price gains, we need no further explanation that the positive framework continues to expand. But even more important than these three factors has been the trend of the US dollar—as we have often stated, this price is the single most important factor for emerging markets. During that same late January timeframe the dollar index fell 4% before re-tracing about half that move and falling further after the Fed meeting (see chart below). The level of that index is now the lowest it has been since last October. But much more important than that level is the trend, and the underlying driver; the divergence in developed market monetary policy has effectively closed given the new Fed information. That development will give ongoing support for emerging markets—after all, the stratospheric dollar rise since mid-2014 was jump-started by a Fed promise to raise interest rates while other central banks ran in the opposite direction.
What follows from these supportive factors is the potential oxygen for the EM recovery—liquidity into the asset class. Measured from one perspective—the rate of change of foreign exchange reserves—liquidity has risen sharply. Measured from another perspective—the ability to issue debt—sovereign issuance jumped sharply in the last six weeks after a historically slow start to the year. Measured from a third perspective—fund flows—liquidity has also turned sharply positive from negative. Our risk appetite in this asset class is predicated on a simple, intuitive, historically reliable fact: when the rate of change of liquidity into the asset class rises, asset prices tend to follow upwards. Though we cannot predict the future, it is historically unlikely that the rally would stop in its tracks without a sign that those flows are waning, although its pace will likely slow.
The counter-argument to this seemingly optimistic scenario is that fundamentals remain shaky, corporate debt has levered up and now has limited market access, and growth will be slow to return. All of those points are hard to argue with. However, liquidity has always preceded fundamentals, whether up or down. So some improvement as currencies rally and central banks either stop hiking or cut interest rates is a high probability.
The last point that is continually impressed upon us as we talk about the asset class with potential and current investors, is that we frankly do not see an appropriate perspective around emerging markets given the evolution of developed markets after the global financial crisis. So investors bemoaning emerging market growth of 3.5-4% instead of 6% are waiting for a world that may not exist, given that developed markets now do well to produce just 1.5% growth. Investors waiting for emerging market dollar debt to yield 9-10% before buying are ignoring a world where 24% or so of the global government bond index trades at negative interest rates in a yield-starved world. And investors worried about excessive issuance that rushes in to dampen the rally are forgetting that sovereign issuance was set to be close to negative on a net basis this year—added to that, the new ECB stance is incentivizing Euro-issuance that will inject an additional positive technical into the market. In the world we have before us, we believe there still seems to be good value to emerging market assets.
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