Fixed Income

EMD Relative weekly notes

Week Ending January 13, 2017

01/17/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

With the Trump reflation trade on pause, the US dollar index (DXY) has been well-behaved this month, slipping from a peak of over 103 to about 101.5 as of this writing. As has nearly always been the case, a stable-to-weaker USD has been a catalyst for better EM local debt returns. While the index this month as a whole is down about 1%, that return is deceptive given the free-fall in both the Mexican peso (down over 7%) and the Turkish lira (down over 11%).

The path of the US dollar this year is likely to determine whether local or dollar debt is the best performing sub-sector in emerging markets this year, in our opinion, and the dispersion around those returns could be substantial. A stable-to-softer US dollar as a result of policy shifts in the US would likely result in local currency debt out-performing the dollar side. Within local currency debt, further return dispersion is likely on a country basis. Countries like Russia and Brazil have performed well almost independently of US dollar moves, given the idiosyncratic drivers of oil for Russia and local politics and monetary dynamics for Brazil. Mexico, of course, has been hostage to US election results and now US policy uncertainty, while Turkey has suffered from negative political dynamics and a lack of a firm policy response to currency weakness.

For Mexico, a period of heightened uncertainty over fundamental shifts as a result of the US election should keep the market on edge, but the significant under-performance relative to other EM currencies has now gone on for over a year. Rates above 8% for longer duration local assets are now among the highest in the asset class. So the risks associated with the market have become more balanced, we feel, all else being equal.

In Turkey, the government is now scrambling to tighten monetary policy without explicitly raising rates and risking further softness in an already weak growth story. The currency has substantially under-performed even Mexico over the last three months. It’s unclear whether investors will consider the current policy moves enough or whether a clear, meaningful hike in rates is both necessary and sufficient to turn things around. While Turkey has both political and growth challenges, a true economic crisis seems unlikely so here, too, the risk profile has become more balanced, we believe.

All of this is to say that just like bonds and stocks in the US may have come too far too fast in pricing in a boost in growth from a US administration that has yet to take office, so, too, the US dollar may be ahead of itself. If that turns out to be the case, the fundamentals in the EM local debt universe may turn for the better at the same time as the US dollar. If that happens we feel EM local currency debt could likely be one of global fixed income's best performing sectors.

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.