Fixed Income

EMD Relative weekly notes

Week Ending December 16, 2016


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

The Fed's more hawkish tone this week put more fuel into the strengthening US dollar trade, lifting the currency to 14-year highs.  We are now on the third large spike in the value of the dollar since the 1970s (see chart below).  Emerging market local debt, which had recovered by more than 2% month-to-date as the Fed met, has weakened in the wake of the decision and the strong dollar.

Source: Bloomberg, DXY US Dollar Index; data as of December 16, 2016. Past performance is no guarantee of future results.

It is probably far too early to hope for a sharp reversal of the kind that historically seems to happen when the dollar is at extended levels. Rising US rates, large and increasing rate differentials with other central banks, and a further divergence in policies if the US turns to fiscal stimulus all argue for continued dollar strength. Therefore, we feel it is reasonable to assume that local currency will become the least fruitful place to invest in emerging markets in coming months.

Unfortunately, most investors and almost certainly the popular press will equate the entire asset class with this one sub-sector. Such groupthink will potentially represent a missed opportunity. This month, despite the US election results and the European Central Bank (ECB) and Fed meetings, dollar EM spreads tightened by around 20 basis points to US treasuries. As long as the strong dollar is borne aloft by a story of higher US growth and reflationary policies in general, those growth expectations could well benefit EM dollar debt as well. So it is entirely possible that, given the current set of market drivers, EM dollar debt becomes one of the best performing parts of global fixed income in general even while local currencies weaken, in our opinion.

Of course, the caveat to this outlook would be if the move in US rates or the dollar results in damage to the fundamental economy here in the US, or if they cause an EM-centric crisis that causes the asset class to dramatically underperform. Relative to past episodes, we think the latter is a far less probable outcome given better fiscal accounts, external accounts, and reserve levels than in previous episodes of significant dollar strength. 

Our last point is that there is a common assumption that the market has priced in a lot in terms of policy shifts, so even if the policies do materialize one path for asset prices could simply be stability around current levels. If that were to happen, returns in 2016 show that it doesn't take a sharp fall in the dollar to drive a much more positive outlook in EM FX, just stability; after all, at one point this year local currency returns YTD had topped 17% (prior to the October rout). So while we are negative on this particular subset at present, this view can change in short order. As to when that might happen, we think the US dollar and liquidity flows into the asset class ought to serve as reliable indicators.

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.