Fixed Income

EMD Relative weekly notes

Week Ending January 19, 2018

01/25/2018

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

European Central Bank (ECB) notes that hint at some "hawkishness" last week are in our view positive for EM local currency bonds. There are additional positive factors at work as well. Meanwhile, "mainstream" EMD remains pricey relative to its own history.

The market reaction to ECB notes suggests that any attempt to move up its tightening schedule will be met with a positive reaction to the currency. The Euro broke out of a recent range to finish over 1.20 to the dollar and remains near recent highs today. The suggestion that even if the Fed continues to hike this year that other central banks might tighten more over the next two years starting from current levels is in our view positive for EM FX. Relative tightening matters: since mid-December the DXY US Dollar Index has fallen by 3.7%, and the local currency index as represented by the JP Morgan GBI-EM Global Diversified is up over 3%.

By now, markets should have thoroughly disabused themselves of the notion that higher overnight rates in the US will translate into a stronger US dollar in any environment. Aside from the relative tightening perspective, other analysts have pointed out that a bigger fiscal deficit in the US has in the past been associated with dollar weakness, and a further deterioration in the current account as a result of strong US growth could also add to the trend. For EMD investors, it all adds up to an investment thesis that the asset class in general, and EM local currency bonds in particular, should continue to perform well.

There is about an 80% correlation between the sovereign dollar index (represented by the JP Morgan EMBI Global Diversified index) and the local currency index, so the positive tone for financial flows and currencies will assist in keeping a positive tone to dollar bonds if history is a guide. Yet the starting point for sovereign dollar investing is not unambiguously appealing--spreads are 11 basis points from their 5 year tights to treasuries. Passive investors have driven substantial value from these mainstream bonds. While they may out-perform the rest of global fixed income in a tightening environment, absolute returns should be more modest.

Corporate dollar debt across the spectrum of rating categories out-yields sovereign dollar-denominated bonds, and duration is generally shorter--an important point in an environment where treasury spreads are threatening to rise at least modestly. Corporate debt has not out-performed sovereign debt since 2015--by a slender 10 basis points.

For those investors just considering the asset class, these value and driver considerations should suggest that a diversified approach across the asset class with a bias away from the run-of-the-mill hard currency sovereign only investing will in our opinion likely continue to out-perform other fixed income alternatives.

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.