Fixed Income

EMD Relative weekly notes

Week Ending February 3, 2017


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

An important correlation breakdown occurred in mid-January that is now apparent, and we believe it helps to explain the fast start for EMD asset prices year-to-date.  To the extent this divergence continues, it would be very positive for those asset prices going forward, in our opinion.

The "Trump trade" since Election Day had been marked by a trio of rising rates, rising equities, and a rising US dollar.  While the first two have remained elevated, the dollar de-correlated and has been softer since January 16 (see chart below).  On that date, President Trump declared his belief that the dollar was too strong, and that pronouncement has been followed at least twice by his advisors delivering essentially the same message. That has moved the dollar index down about 4% from its post-election peak, and a softer dollar has been a consistent ally of emerging market assets--equity, debt, and currency.  The local currency index is up over 3% for the year as a result.

Source: Bloomberg, DXY US Dollar Index, Generic US 30 Year Treasury Yield; data as of February 3, 2017. Past performance is not indicative of future results.

While we had our doubts that simply talking the dollar down would be effective given the current economic state, we have been wrong.  Perhaps the market is simply struck by the unprecedented nature of a consistent chorus from top US officials jawboning for a weaker currency.  Clearly, hopes for a fiscal stimulus package or at least growth-inducing regulatory rollback remain high, and today's US jobs number which was well above consensus suggests the actual data is arriving in a way that has been traditionally positive for the US dollar. 

So for now at least the administration has achieved its aim.  The longer this works, we believe the more positive it is for EM currencies and EM fundamentals.  Stressed countries like Turkey and Mexico will not have to tighten policy further to compensate for weak currencies, and growth prospects will eventually brighten, while inflation caused by previous currency weakness fades.  

We have noted that at the same time that the dollar has de-correlated from rising rates and equites that there was a pick up in foreign exchange reserve flows into EM countries that report them on a high frequency basis. Russia has even set as a policy goal the steady accumulation of additional reserves.  All of that is a boost to creditworthiness.

So while the conventional wisdom had been post-election that protectionism and nationalism would be terrible for emerging markets, that viewpoint has been overturned by the positive effects of a weaker dollar apparently becoming a policy cornerstone.  That environment has historically led to robust gains in EM asset prices, and we believe this time could well be no different.

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.