Fixed Income

EMD Relative weekly notes

Week Ending July 14, 2017

07/20/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

The market's fear over the end of quantitative easing (“QE”) globally and a subsequent back-up in bond prices may have run its course, at least for now. Over the past two weeks, when it became apparent that the European Central Bank (“ECB”) would begin to wind up QE sometime later this year, the Bank of Canada would hike rates (which it did this week) and the Bank of England would likely move forward rate hikes, developed market bond prices suffered and the 30-year in the US went from a 2.7% yield to about 2.93%. However, the momentum of that move lost steam this past week.

The concurrent back up in EM yields, spreads, and currency levels followed developed markets closely. ETF inflows into the asset class have become a near-perfect daily barometer of that sentiment, in our view. Just over $1 billion left the biggest ETF, iShares JP Morgan USD Emerging Markets Bond ETF (EMB), in the two weeks preceeding this week, with outflows every single day. Spreads in the primary EMBI Global (EMBIG) index widened by 15 basis points during the same period. As treasury yields and other markets steadied this week, we have seen inflows and tightening spreads every day as of this writing.

The table and chart below compares the outflow episode just completed (we hope) with that of the post-US election period. This downturn has been shorter and sharper, and, as in the past, resulted in the out-performance of EM corporates versus sovereigns during the downturn, and the opposite when risk appetite returned. We expect this dynamic to be a regular feature of EM markets going forward given the growth in passively managed assets, and one of the arguments for active managers to manage with the broadest and most flexible possible mandate against the entire opportunity set. This will, in our opinion, almost certainly be the highest probability path for active managers to out-perform in EMD.  

Source: Bloomberg, JP Morgan. EMBI Global Index and CEMBI Broad Diversified Index (table), iShares JP Morgan USD Emerging Markets Bond ETF assets under management (graph); data as of July 14, 2017. Performance shown reflects past performance which is no guarantee of future results.

One of the reasons why it might not be a surprise that a market correction caused by end-QE fears was short, sharp, but not truly significant is because it’s difficult to believe that the withdrawal of global QE will result in anything like the "normalization" of interest rates, and Fed chair Yellen said as much in Congressional testimony this week. So market fears that the withdrawal of QE will result in rapid rate rises will naturally be bounded by the fact that growth and inflation are structurally weighted down by debt, demographics and lower productivity in the developed world.

If this is true, investors in the developed world, particularly pension funds, will continue to have an increasingly pressing need to generate income. That makes the search for yield structural instead of cyclical. Global investors thus are logically expected to continue to accumulate emerging market debt exposure. That is one of the reasons why we think that comparing current EM spreads relative to lengthy historical periods in EM is misleading the world has changed, and tighter EM spreads are a natural consequence of the nature of those changes. 

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.