Economics

EMD Relative weekly notes

Week Ending March 30, 2018

09/04/2018

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

The onset of global equity weakness has sparked a bout of volatility that has roiled all asset markets globally, right? 

Not really. 

Emerging market currency volatility has been sharply declining--see the attached chart. With the US dollar index trading in about a +/- 2% narrow range from the start of the year, the local currency index in EM has returned close to 5% for the first quarter. Apparently markets have concluded that while there might be considerable uncertainty surrounding rate hikes, trade wars, growth and equity valuations, the dollar is well anchored. That bodes well for an eventual recovery of the dollar side of EM.

Source: JPMorgan and Bloomberg; as of March 29, 2018

There is an historical 80% correlation between the two primary dollar indices and the local currency index. The nearly 7% deviation in a single quarter in performance (in favor of local currency) is a large historical anomaly, perhaps one of the sharpest deviations in the history of the asset class. We expect this historical correlation to eventually re-assert itself.

The strong recent historical performance in local currency has allowed EM countries to, in general, continue to accumulate reserves, complete interest rate cutting cycles, and to expand growth moderately. All of that, we think, should eventually give investors confidence that dollar EM represents significant value after a sharp bout of price sell-offs and spread widening.

With yield curves globally flattening and short duration bonds under pressure in particular, we find USD-denominated shorter duration EM bonds in improving credits to be significantly attractive at present. As long as the US dollar remains anchored, we see no particular reason for EM currencies to selloff sharply but gains should naturally be more modest going forward. But the resumption of historical correlations would result in dollar bonds performing very well in that environment.