Fixed Income

EMD Relative weekly notes

Week Ending November 17, 2017

11/21/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Emerging market debt has wobbled this month with all three major indices in modestly negative territory.  Fund flows this week were negative, and in US high yield we had the third largest weekly outflow ever, which often produces a knock-on effect on EMD. It is certainly reasonable to presume as one proximate cause for the softness that investors would like to lock in profits, and this could continue.

But selling higher-yielding fixed income instruments without evidence of fundamental deterioration is in itself a risky exercise. Of the 15 largest daily outflows in US HY, next three month returns have been positive two-thirds of the time, with an average annualized historical return of 7.2% according to Bank of America. 

We often get questions about how we believe EM would fare in negative market environments or when a clear negative global event happens and our answer is always the same—it is our opinion that they would react similar or perhaps better than other risk asset classes, absent a cause that is specific to emerging markets. This month is a stellar case in point as US equities are down slightly for the month while European equities have fallen around 3%—in that context we think the < 1% fall in EM assets (excluding the 30% long-awaited collapse in Venezuela) is a reasonable response and is a better performance than that of US high yield during this short recent period.

Going forward we do not see a sign that we are in an environment that would be meaningfully negative for EM in particular. The continued, relentless flattening of the US yield curve leaves EM yields yet more attractive to fixed income investors, not less. The dollar index has fallen about 1% this month—we would be far more concerned if a rising dollar accompanied a period of higher volatility. Lastly and perhaps most importantly we see that high frequency foreign exchange reserve data is stable to positive across those major countries that report weekly. In summary, there is an absence of historically reliable indicators to suggest we are entering a period of heightened risk in this asset class.

However, that flattening of the yield curve could well induce a period of profit-taking in US equities should the market conclude growth prospects in the US are dimmer even with a tax reform package as the Fed tightens liquidity conditions. In that case we would expect further wobbles in EM. But there is hardly enough support for that thesis to be dogmatic about it, and foregoing income potential to bet on it is not a risk-free proposition.

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.