Fixed Income

EMD Relative weekly notes

Week Ending March 24, 2017

03/29/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Here is why, broadly speaking, conditions are so favorable for emerging markets fundamentally in 2017, in our opinion.

Our story begins in 2013, when the Fed began the slow extrication from quantitative easing (“QE”) amid the famous "taper tantrum." EM currencies took the brunt of the damage as the US dollar began a massive rally of approximately 20%, leading to cumulative performance of the local currency index of negative 29.6% over the three years ending2015. During this period currencies in the index were down on a nominal basis, on average, 50% (source: JPMorgan). Unlike other deeply negative environments for EM, there was not a single major negative event or risk catalyst like the Mexican peso crisis, the Asian crisis, or a US equity crash--just a slow, painful bleed that by contrast seemed to happen in a somewhat stealthy manner. That, and the fact that there was no serious default or credit crisis in the asset class, allowed this period to go under-appreciated as a painful adjustment period.

But quietly painful it was, and broadly speaking foreign exchange reserves fell, inflation rose sharply and interest rates were forced to rise in response with growth falling as well. However, in hindsight, it now seems like January 2016 marked a turning point as the Fed put off a series of rate hikes in response to global growth fears causing the dollar to stabilize. The local currency index rose 9.9% for the year, but that was only in line with the rest of the major EMD indices. Today, even though the Fed is hiking rates, other developed world central banks are heading in the same direction, and perhaps the Trump administration's focus on trade is keeping the dollar subdued.

With that background, 2016 seems today like a year of quiet healing. thus far in 2017, we are seeing the unwinding of this negative cycle gaining speed. Even as growth stabilizes at twice the growth rate of the developed world, inflation is falling towards developed levels--see chart below. That is making real interest rates attractive--especially relative to the developed world--which is drawing capital, causing currencies to appreciate and allowing central banks to cut rates. And foreign exchange reserves are rising, serving as a building block to improving credit quality.


Source: Thomson Datastream, Schroders Economics Group calculations. Updated March 23, 2017. EM inflation is a GDP-weighted mix of the following CPI statistics: Brazil, Chile, China, Colombia, Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Peru, Philippines, Poland, Russia, South Africa, South Korea, Thailand, Turkey, and Taiwan. DM inflation is a GDP-weighted mix of the following CPI statistics: Canada, France, Germany, Italy, Japan, Russia, United Kingdom, and United States.

Because of the severity of the currency fall that preceded this period the runway seems long for a virtuous cycle, and the inflation story becomes important because the convergence suggests real rates on a comparative basis will continue to be attractive in EM through a pronounced currency appreciation cycle. In the meantime, overall credit quality of emerging markets versus developed markets will continue to improve. Little wonder that this week's retail funds flow data showed the strongest positive flows since last July. Even if dollar debt spreads began the year at somewhat historically rich levels compared to developed markets, that suggests more tightening can happen, and local currency returns could be extremely generous in select countries.

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.