Fixed Income

EMD Relative weekly notes

Week Ending April 7, 2017


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

In this particular economic cycle, it could turn out that emerging market (EM) debt works as a clever hedge for exposure to US equities. This would not be unprecedented, but it would be unusual--throughout most of the history of EM, it has acted as the tail of the developed market dog--falling in concert as macro storms rose, and rising together as policy fixes or simple value emerged. The two keys to this thesis will be US growth expectations and the trajectory of the US dollar.

This week we have seen auto sales and non-manufacturing ISM numbers come in weaker than expected. For the first time since the election, we seem to be entering a period when economic data disappoints expectations on an extended basis--see the chart below of the Citi US economic surprise index. Markets had already begun to discount quick passage of reflationary policies in the US, but have not, it seems apparent to us, begun to consider that growth could flag independently from any policy action.

Source: Bloomberg, Citi US Economic Surprise Index, data as of April 5, 2017

A second factor was the release of Fed minutes on Wednesday, when equity markets turned the moment they were released and kept falling throughout the afternoon. The suggestion that the Fed's balance sheet could begun to be unwound for both treasury and mortgage-backed securities (MBS) holdings suggested a Fed that was optimistic on growth and normalization--something markets, in contrast, seem markedly more skittish on.

Since the Fed's March rate hike, the treasury curve's flattening had suggested that at least the bond market was growing more circumspect on growth expectations, but now we are beginning to see the data to back up that thesis.

For emerging markets, the interesting point is that this comes at a time of extended US dollar strength. If the dollar retreats from historically high levels as a result of this growth outlook changing, we believe that capital will almost assuredly flow into EM countries if history is any guide. That would likely provide further fuel to the growth in foreign exchange reserves, and creditworthiness, we have seen since the start of 2017.

Concurrently, the asset market with the sunniest growth prospects embedded is arguably the US equity markets. Thus, we think the evidence accumulating for softer US growth prospects is a meaningful plus for the prospects of EM assets out-performing DM assets going forward.

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.