Fixed Income

EMD Relative weekly notes

Week Ending July 28, 2017

07/31/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

If you think of the proposition that the US dollar is in a weakening cycle as a scientific thesis that needs continued confirming evidence, the Fed provided another piece this week by signaling a moderately more dovish stance given low inflation.

As a result the DXY US Dollar Index slipped another 75 basis points this week.

History demonstrates that a weakening dollar environment is generally a strong positive for EM assets. It further shows that dollar cycles are multi-year affairs. The current cycle can be dated from January of 2016, and for that year the major EMD indexessovereign, corporate, and local currencyeach gained around 10%. This year, the two dollar indices are up 6.9% for sovereigns, 5.8% for corporates, and over 12% for local currency as measured by the JP Morgan EMBI Global Diversified, CEMBI Broad Diversified and GBI-EM Global Diversified indices, respectively.

Though the backdrop for EM remains robust, the optimal investing strategy will likely evolve. As central banks lower interest rates in response to positive liquidity environments, the odds for yield compression across countries will diverge with the differing paces of monetary policy for each country. At the same time, dollar yields on lower-rated credits whose default probabilities decline with better growth will start to look more attractive relative to what investors are getting paid to assume currency risk, even in a benign environment.

So to have a high probability of a positive outcome, our view is investors don't need to assume 100% currency risk—this is a misconception we often run across from generalist investors. Even in a good market environment, the volatility of that approach is daunting. For instance, in May of 2016 the local currency index fell over 5% in that single month, and then another 7% in November post-US election—yet the return for the year was in double digits—our hats are off to those willing to stomach that volatility.

A more balanced approach would favor spreading exposures across the broader opportunity set. It is critical to consider correlations: the local currency index has a historical 80% correlation with the two dollar indexes (sovereign and corporate) and those two indexes have a 92% correlation with each other. We believe the rising tide of the positive environment should benefit all exposures to emerging market debt as a general principle, and as this cycle continues forward the argument for a blended approach to manage risk and volatility is likely to gain strength.

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.