Fixed Income

EMD Relative weekly notes

Week Ending December 15, 2017

12/19/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

In our last missive of the year, we'll take a stab at the one emerging market debt question we believe investors get wrong most consistently: the way to think about local currency investing in the context of the entire opportunity set.

First, there is an historical 80% correlation between hard and local currency investing. That suggests the direction of probable results is going to be very similar. The dispersion of those results, however, varies on the macro driver: if the dollar is prominently stronger or weaker, local currency will either out-perform or under-perform dollar-denominated opportunities. We find that virtually all investors are aware of this, and this is where their analysis of the opportunities typically stops. But in reality that is where it actually just starts, so let's call that the first layer of complexity.

The second layer is correlations. Having a completely independent allocation to dollar and local invites the risk that country exposures will be doubled up to an extent that overall risk becomes unacceptable--who wants to make their emerging market exposure riskier than it already is? But there's more. Twenty percent of the JP Morgan GBI-EM Global Diversified local currency index has an 85-90% correlation to the Euro via Poland, Hungary, Czech and Romanian exposure--does the investor mean to be making a Euro call? Over 14% has a reasonably high correlation to oil via Russia and Colombia--but central bank actions or other risks can make those correlations shift. Then there is, excluding the European complex, about 16% of the index with quite low nominal yields akin to many developed countries--would you bother with those paltry yields on a standalone basis?

The third layer of complexity is volatility. Unless you possess a super-human ability to time markets, this should induce a level of caution. Many improving credits possess low volatility but these are often small parts of the index--Argentina is currently in this camp due to central bank efforts in fighting inflation--or not in the index at all, like Egypt. Bigger parts of the index like South Africa, Turkey, Brazil and Mexico, if perceived to be going through a period of fundamental deterioration or improvement, can produce returns wildly at variance with the rest of the index that last for completely unpredictable periods.

Lastly, and most importantly to us, is the fourth layer of complexity. This level is the trade-off between dollar and local currency opportunities. With a significant portion of the local index possessing skimpy yields, many dollar-denominated opportunities will often be better uses of capital--because of the 80% correlation in direction we pointed out at the start. Secondly, in certain countries with shaky fundamentals (like South Africa for example), investors can consider a 7% quasi-sovereign dollar bond versus a 10% local bond with much less volatility as a better way to gain exposure. Exclusive allocations to either local or dollar can eliminate an opportunity to gain the best risk-reward proposition for many countries.

In sum, the most simplistic way to consider the trade-off--strong USD or weak USD?--is unlikely to be optimal except when the dollar is either significantly weak or very strong. These periods tend to be short and unpredictable. In the face of so many moving parts, the only way to access emerging market debt with a high probability of achieving the best results is, in our opinion, is to avoid structurally over-or under-weighting dollar and local.

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.