Fixed Income

EMD Relative weekly notes: Week Ending November 21, 2018

11/21/2018

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

The sell-off in US equities portends, to many investors, a more modest Fed hiking cycle, as the market has priced in only a 10% chance that the Fed hikes three times in 2019 (their stated intention). Despite what should—in normal markets—be a positive sign for EM debt, dollar debt spreads-to-US treasuries have widened considerably, reaching an 18-month high of 385 this week.

The correlation of these spreads to US equities is a relatively rare event, and one that heralded the climax of the sell-off in the last period of EM weakness in 2014-early 2016.

Figure 1 shows the extremely tight correlation between the S&P Index (in white) and the sovereign spreads (inverted, in orange). The peak of spreads in 2016 happened in conjunction with the bottom in equities, as former Fed chairperson Janet Yellen stated unambiguously at that point that market stresses merited a more dovish approach to the coming rate hiking cycle.

Source: Bloomberg and JPMorgan, as of February 29, 2016. Data is the SPX Standard & Poor’s 500 Index and the JPMorgan EMBI Global Spread Index (JPGCSOSD). Past performance is not a guarantee of future results. Actual results would vary.

This time around shows a very similar picture. Of course we have no idea where the bottom for equities and the top for spreads are, but the similarity between cycles is instructive. The Fed is unlikely to respond to market pressures in emerging markets alone, but US equity sell-offs that represent tightening financial conditions and dwindling US growth prospects may eventually get addressed. In that sense we think the correlation should be welcomed by EMD investors. When the Fed does address the market volatility, history suggests emerging market assets have the potential to perform well as the double-digit returns of 2016 and 2017 demonstrated, historically.

Source: Bloomberg and JPMorgan, as of November 16, 2018. Data is the SPX Standard & Poor’s 500 Index and the JPMorgan EMBI Global Spread Index (JPGCSOSD). Past performance is not a guarantee of future results. Actual results 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.