Fixed Income

EMD Relative weekly notes

Week Ending October 6, 2017

10/11/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Dear prospective or current EMD investor,

The last two weeks have offered you an excellent learning opportunity in drivers, cycles, and sectoral investing in EMD.  Summarizing your lesson:  never, ever invest all of your EMD exposure in local currency.  To paraphrase Jack Nicholson in "A Few Good Men":  "You can't handle the vol!"

Over the past two weeks the JP Morgan GBI-EM Global Diversified local currency index has shed nearly 2%.  From the early September peak it is down 2.65%.  Meanwhile, the dollar sovereign and corporate indices (as represented by the JP Morgan EMBI Global Diversified and JP Morgan CEMBI Broad Diversified indices, respectively) have combined to return about 35 basis points of positive return. 

Understanding the drivers and the sub-sectors available in EMD is key here.  The current EM FX downdraft has been caused by a stronger USD, boosted by the market pricing in a higher probability of a December Fed rate hike and stronger economic data.  For strong dollar cycles driven by great growth prospects and a solid risk appetite (like the current mini-cycle), we believe credit risk should generally do well in our asset class, and indeed dollar corporates have outperformed.

If that dollar cycle were driven by a risk-off mentality, interest rate risk would have been expected to have out-perform.  There are ample instruments available in the asset class to efficiently gain exposure in any of the three traditional risks of interest rate, credit, or FX.  But, inevitably, choosing to allocate all in on one risk component for your EM exposure will likely not give you satisfactory results over any reasonable investing time horizon, in our opinion.

Still, we feel there are also local currency opportunities lurking.  The chart below shows the two-year Treasury bond in the US and the three recent peaks around March, June and now.  Each represents the market pricing in a higher probability of a near-term Fed hike, and each was accompanied by around a 3% fall in the EM local currency index.  Afterwards, local currency did just fine.  Now, the current episode could be different, if this hike represents the start of multiple hikes.  Or the market could remain skeptical and EM FX could resume its rise.  Neither you nor we will know the answer until it unfolds.  So why place all your chips in one basket, when surely there are generous income producing opportunities in each whatever the answer might be?

Source: Bloomberg, US 2 Year Treasury Yields; data as of October 6, 2017. Past performance is no guarantee of future results.

 

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.