Fixed Income

EMD Relative weekly notes

Week Ending July 6, 2018

07/17/2018

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

On April 16th the US dollar began rising sharply as US growth appeared solid while that of Europe and the rest of the world seemed to slow. The rise in the dollar was the key contributor to EMD's roughly 5% fall in returns this year. That dynamic may no longer be operative, in our view.

The dollar index (as measured by the DXY Index) over the past three weeks has been flat, and this month has fallen about 1%. Just as the divergence between the rest of the world and US prospects drove the dollar rally, so a closing of that divergence can help us understand where we are now.

Although US equities continue to exhibit strength, other signs that would suggest slower US growth abound: a continued flattening of the US yield curve, a 15% fall in the price of copper in the past month, and a common understanding that the current trade war is negatively affecting future growth prospects in the US.

The Citi economic surprise index has been telling. A sharp drop in the European version of the index to start the year heralded one side of the strong dollar regime as those expectations were realized in softer EU data, with a lag of a few months. The US version of the index has fallen notably since April, though at a softer rate. In June, however, the Euro index once again began to rise (Figure 1).

Figure 1

Source: Bloomberg, as of July 6, 2018. Past performance is not a guarantee of future results.

The combination of all of these factors helps to explain the dollar's recent path. With that change of course, this month the EM local currency index is in positive territory after three sharply negative months, and dollar EM spreads are 15 basis points below their mid-June peak.

Is this a durable turn in EM prospects? Of course, only in hindsight will that be clear. But we do believe the market’s conviction that the Fed tightening cycle may wrap up sooner than had been expected three months ago, coupled with some growth resilience elsewhere, are leading to an encouraging environment for an asset class that has been disproportionately bruised year to date.

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.