Fixed Income

EMD Relative weekly notes

Week Ending April 28, 2017

05/02/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Retail flows into emerging market debt (EMD) funds this week were over $2 billion for the seventh time this year. All three sub-indices in the asset class (hard currency sovereign, local currency sovereign and corporates) will likely finish the month up over 1% and on a blended basis, the total return for the indices will likely be over 5.5% year to date.

Part of the driver for such a strong start to the year has been the reversal of the reflation trade from Q4 of last year, which resulted in both a somewhat weaker dollar and well-behaved treasury yields as well as optimistic growth forecasts. While fundamentals for the asset class continue to improve, we would be remiss to overlook factors that could derail the current rosy consensus view.

A soft Q1 growth number in the US, if coupled with a Fed insistence on validating hiking expectations next week, could reduce risk appetite. If it appears that the Trump tax plan can actually get through Congress, it would in our opinion likely cause the market to re-consider the softer US dollar. Given the market's shrugging off of the announcement of the plan, the bar seems set pretty low for movement that would cause that re-think.

While EM fundamentals continue to be strong, our point is that the stable-to-softer dollar story, which we hold largely responsible for both flows and performance in EM so far this year, will need continued, periodic validation if the rally is to continue. That is why we believe investors are always well advised to consider exposure to the local currency part of the opportunity set as an allocation that needs constant review, and is best taken in conjunction with income-producing dollar positions that modify volatility. One need only remember back to November's 7% local currency index drop for the month to recall that lesson.

A final issue that appears to us to be reaching a potential climax is Venezuela. It has become clear over the past two weeks that the opposition to the current regime will now be a constant force on the streets after any hopes for a democratic-like resolution have been effectively extinguished. Virtually no economic data is available, but it is clear that the size of the economy is shrinking rapidly and inflation is likely reaching four digit annual heights while oil production falls.

Investors should consider that Venezuela is 3.8% of the major index for EM, and the ninth-largest country constituent. A default for a country of that size would be the largest credit event in over a decade. One might think that the event has been well telegraphed, yet a Venezuelan bond maturing in August of 2018 is currently trading at an $85 dollar price. Perhaps the only explanation is that the yield available in Venezuela is at most points on the curve over three times that of other high yielding bonds. It’s tough for a manager to ignore that. However, the assumption that the country can make the next interest payment just because they made the last one should be increasingly suspect. There is no rational way to assess data, reserve levels, or the motives of key actors. Given the level of complacency as evidenced in short-term bond prices, a sudden stop will be seen as a shock. We believe that is an increasingly likely outcome. We have in the past held Venezuelan debt but have no longer been able to justify those unquantifiable risks. The underlying assumptions of those who continue to hold it should come under increasing scrutiny.

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.