Fixed Income

EMD Relative weekly notes

Week Ending October 27, 2017

10/31/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

The dollar has continued to rise, never a good thing for emerging market currencies. Yet to be determined is whether this represents a turnaround in the dollar trend--which would be historically unusual given the relatively short lived depreciation cycle--or a bump in the road.

The Fed's next rate hike, presumably in December, has been priced in to close to 90% according to the Fed Funds futures market. In previous Fed hikes periods, we have seen the dollar rise, the two-year Treasury yields rise, and EM FX sell off just over 3% before consolidating and then rallying. In prior hiking episodes, the two year yield rose sharply to about 15 basis points above where the new overnight rate would be, and then falling to a new (though higher) low. We are almost at that level for the current episode.

The fall in EM local currency from the near-term peak, though, has been the sharpest of the year--down 4.5%. We attribute at least part of that to a belief that the US would enact some fiscal stimulus which would lead to a more durable dollar rally.

While no one knows how that particular story will play out, history has shown that currency corrections in EM that occur without a sustained dollar rally tend to be short and sharp. Therefore in our view at least some exposure to local currency remains warranted--but certainly not a significant allocation at this point.

One of the things least appreciated about this asset class, though, is the way the different opportunities move during different periods--and that there is almost always a way to make money as macro trends unfold. Despite the EM FX correction, over the same time period that the correction occurred, dollar sovereign spreads over treasuries actually fell 14 basis points--providing comfortable out-performance against the global fixed income universe during this specific time period.

One of the longer-tailed drivers behind that dollar dynamic has been steady credit quality improvement in the asset class. The chart below shows the percentage of investment grade credits in the main JPM sovereign EM index, which had fallen steadily as major issuers were systematically downgraded until beginning to rise in the first half of this year. That credit quality improvement, in our opinion, justifies tighter spreads to treasuries—and is reason enough to maintain a diversified approach to the asset class while the dollar story unwinds.

Source: Bloomberg, JP Morgan; data as of September 30, 2017. Past performance is no guarantee of future results. Investors cannot invest directly in any index. Actual portfolio constituents’ credit quality would vary. 

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.