Fixed Income

EMD Relative weekly notes

Week Ending July 21, 2017

07/26/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

In our opinion it should not be a contentious investment thesis to suggest that emerging markets are one of the best, if not the best, ways to invest in an era of a declining US dollar. Here is where real interest rates are the highest, available yields are the most generous, and the fundamental landscape is most positively affected by a weaker USD.

And that has been the recent investing environment, in place arguably since January of 2016 with a respite in the form of the Trump “reflation” trade that history may judge to have been very brief, as it officially lost steam late in December of last year. Although there have been some popular press articles about the weaker dollar, it has certainly not been an investment theme that has captured the popular imagination. Perhaps that is due to an infatuation on still soaring tech stocks, or because a weaker USD view is about 180 degrees from the view which prevailed a scant few months ago, and it will take a decent interval for pundits to embrace a divergent view on a different trend.

And "trend" is really the operative view. The chart below shows the dollar index since the Plaza Accord in 1985, and multi-year trends are the rule--both up and down. Arguably, the “up phase” began in 2011 lasting until January of 2016, marking an average period for a broad dollar trend. The current downtrend in the dollar would appear to be somewhat of an historical anomaly if it were to turn around in a sharp fashion, history shows.

Source: Bloomberg, DXY US Dollar Index, data as of July 21, 2017. Performance shown reflects past performance which is no guarantee of future results.

Thus, given those facts, EM local currency and dollar bonds very well could, if history is any guide, have a multi-year period of returns above those of any other global fixed income alternatives.

However, we expect few to believe the preceeding sentence. From 2013-2015 local currency was the worst-performing sub-sector for EM investing, losing a cumulative negative return just under 30%--the worst period in its history by a massive margin. The scars from that still resonate with investors and consultants more than two years on despite the 20% return over the past 18 months for the local currency index.

But one need not accept the sometimes numbing volatility that can come with a full-on exposure to EM local investing. A weaker dollar will also buttress the underlying rationale for investing in dollar-denominated EM. Foreign exchange reserves across the asset class are steadily rising as liquidity leaves the US and ventures elsewhere. Those growing reserves underpin eventual improvements in credit quality, as do lower interest rates that follow appreciating currencies. Thus, EM spreads over Treasuries should stay low in aggregate once better credit quality is recognized. Ultimately countries and companies will reduce funding costs should those underlying positive trends continue.

In short, we believ there is accumulating evidence that we are in a weak dollar regime, which will disproportionately benefit emerging markets. Emerging market debt comprises about 18% of the total global debt stock (source: BAML). We have a long way to go until that evidence becomes conventional wisdom, and much farther still for investors to proportionately allocate their holdings to EMD.

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.