Fixed Income

EMD Relative weekly notes

Week Ending June 1, 2018

06/05/2018

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

We believe that the upward trajectory of the US dollar—an unambiguous negative for all emerging markets—which began on April 16th was triggered by the market's growing realization of the divergence between central bank policies: the Fed is steadily tightening monetary conditions while the rest of world is widening. The evidence for that has been slower economic growth signs across Europe and the UK, and no real signs of pick-up elsewhere.

There seems to be no real catalyst for a reversal in the dollar so long as the divergence remains or widens. Without a narrowing of that policy divergence, EM investors should, if history is any guide, remain defensive with little local currency exposure, and ample shorter duration exposure in credit risk bonds.

Is there value to be extracted from dollar EM bonds now under this framework? We think so. Absolute yields are at their highest level since a 2015 peak, and since 2011 prior to that peak. Income generation opportunities are thus at their highest in years.

But a rising dollar implies low odds for capital gains beyond those returns. What then turns things around? The same policy divergence we noted actually sows the seeds of its own demise. The chart below displays 70 years of US unemployment data, and our near-historic low. History suggests we can stay at these very low levels for multiple months, but that a correction is swift—the initiation of which would be a buy signal for EM under our policy divergence framework, as it likely would lead to a dovish Fed.

Source: Bloomberg, JPMorgan. Data as of June 1, 2018. Past performance is not guarantee of future results.

While timing is a fool's errand, the signs are accumulating that those seeds have been planted. Global growth ex-US seems to be slowing, and we would particularly note much softer prospects in the large Latin economies of Brazil and Argentina, as well as in Asia with a gentler slope. In our view, that weakness will feed back into the US.

Positive economic surprises peaked in December and have trended down since, according to the Citi surprise index for the US. All of this represents rather traditional leading indicators that a Fed tightening cycle is maturing, in our view almost certainly more rapidly than published Fed expectations for hikes beyond 2018 imply.

But this week added a new twist, with the broad first shots in a global trade skirmish. It is difficult to find a fact-based argument as to why this, too, should not be a meaningful impediment to overall US growth, especially given a now semi-permanent rise in business uncertainty.

While today's jobs number will certainly lead to commentary extolling US strength and firmer near-term Fed hiking probabilities, we think the higher yields available in EM offer a reasonable “cushion” against potential volatility while we wait for additional evidence to confirm the signs we are seeing that this time is unlikely to be 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.