EMD Relative weekly notes
Week Ending November 11, 2016
The market seems sure of two things: 1) US reflation on the back of greater fiscal spending and the growth that (presumably) is expected to follow; and 2) that politics will join, if not displace, the Fed as the key market driver in the foreseeable future.
Neither is a particularly positive factor for emerging market debt, but the post-election market moves are clearly based on a reading of future US policy that is subject to a very, very wide skew of outcomes. The most obvious is the tension between the two drivers, since aggressive protectionist policies are likely to dampen growth by increasing economic uncertainty that will at least to some extent mitigate the positive effects of more fiscal spending. Nevertheless, there is no denying the swirl of negative post-election sentiment towards EM in general that has collided with the market's increased expectation and pricing of a December rate hike along with a stronger dollar to create a perfect storm for emerging markets in the near term.
Fund flows suggest this negative near-term scenario is likely to persist as they catch up with price action. Daily ETF flows turned sharply negative as this week ended. For now, that means currencies will remain the least attractive part of the EMD opportunity set.
Despite the gloomy scenario, we are already seeing opportunities open up as some market movements border on the irrational, in our opinion. Should Russia out-perform based on the US rolling back sanctions? And should Ukraine under-perform based on a view that Russia would have a freer hand there? Both seem to us to be a big stretch. On the other hand, Mexico is one special case where significant uncertainty will linger, and what constitutes "fair value" for Mexican assets is likely to be determined only by further clarity on the political front that will likely take months to emerge.
Further market movements, in our view, will bring more opportunities. Shorter duration bonds that fall sharply in countries with low default probabilities we feel will be the first, and least risky, place where EMD value opens up. Sovereign long bond spreads continue to widen aggressively and could well represent value if there is any chink in the reflation story as fiscal spending plans are revealed. And lastly, currencies should benefit with greater Fed clarity. The US dollar is quickly approaching multi-year highs, and that should be watched since stability there could reverse EM FX sentiment quickly down the road.
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.