Fixed Income

EMD Relative weekly notes

Week Ending June 29, 2018

07/02/2018

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

A checklist for investing in a battered Emerging Market Debt Market

  • Is the current sell-off driven by emerging markets (“EM”)? This one is definitely not and, in fact, the last EM sell-off that was specific to deteriorating fundamentals in a shaky asset class was probably the 1997 Asian crisis. This one is led by the strong US dollar taking liquidity from EM markets, a classic cyclical sell-off. So no one should expect EM assets to trade broadly at distressed levels; instead cyclical lows will probably turn out to be a better guide.

  • Is EM cheap enough? While beauty is in the eye of the beholder, EM seems cheap relative to its most logical comparator, high yield. However, EM dollar sovereign spreads have widened by about 120 basis points from lows, yet remain about 130 basis points from the spreads experienced in early 2016 at the peak of the last strong dollar cycle.

  • Are the drivers outside the asset class lining up to suggest a potential turn? We don’t believe quite yet, though as with all turning points we think we’ll see this one clearly only in hindsight. What will be needed—most importantly—is a closing in the divergence between monetary policy in the US and rest of world, and for this to occur there will need to be signs of stress or lower growth in the US.

There are a few intriguing pointers in indicators that we think could work to close that divergence. The first is the Citi surprise index, which shows that economic releases are becoming consistently less impressive than expected (Figure 1).

Figure 1

Source: Bloomberg, as of June 29, 2018. Past performance is not a guarantee of future results.

Secondly and perhaps even more forcefully indicative, is the flattening US yield curve. The bond market is indicating in a persistent manner that future US growth prospects are likely to be less robust. What happens when that signal manifests? Figure 2 shows we are in a third period in recent history when the yield curve has flattened aggressively (as measured by the spread between the 10-year US treasury and the 30-year US treasury). The previous two periods resulted in a “healthy” US equity sell-off at some period removed from the bottoming of that yield curve shift. While the Fed may be able to ignore international pressures—which we will discuss next week—the combination of debt and equity eventually signalling a slower growth regime would necessitate action, likely resulting in a softer dollar and a turn in EMD prospects, generally.

Figure 2

Source: Bloomberg, as of June 29, 2018. Past performance is not a guarantee of future results.

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.