Fixed Income

EMD Relative weekly notes

Week Ending July 7, 2017


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Emerging market debt (EMD) is participating in the price adjustment lower in global fixed income, which should be no surprise.  For those who had yet to gain exposure to EMD, that is perhaps the good news.  The not-so-good news is for those who chose "safer" assets over EMD, such as developed market government bonds.  In the last two weeks, the yield of the German government 10-year bond is up a cool 134%, and the resulting price drop wiped out about a decade of carry.  For US treasuries, the 10-year yield has jumped nearly 12%.  With little yield to protect investors, and driven by developed market central banks creeping away from quantitative easing (QE), "safe" government assets are far from havens for wary investors in the current market scenario. 

Of course, EMD will suffer as well, but the question is whether it will do so disproportionately to the rest of the global fixed income opportunity set.  There are two reasons why history suggests it will not do so. 

The first is that the US Dollar (USD) is not appreciating in this risk-off environment.  Over the same two week period the DXY Dollar index is up a miniscule 0.38%, but over a month it is down 1.8%.  So the lower trend for the dollar remains intact.  Foreign exchange reserve levels have shown stability for those countries reporting on a weekly basis.  Were those levels to fall, we would expect EM currencies to depreciate at a pace that would cause central bank policy stances--now pro-growth--to be re-considered, and at that point history would unambiguously suggest that this is not the asset class to be invested in.  Yet we have seen none of that, despite the sharp moves in other asset classes and  the roughly $2 billion of outflows from EMD ETFs.

The second factor that would be specifically negative for EM assets is if developed market fixed income asset prices were to reset to new, higher levels--forcing EM to follow with negative structural repercussions for prices.  We are quite skeptical that we are seeing that process unfold.  The chart below shows the yield of 30-year treasuries (in orange) along with oil since January 2016, which marked the beginning of EM FX currency appreciation and the end of USD strength.  For both assets, despite the two week selloff, we are currently at nearly identical levels to the beginning of the period.  

Source: Bloomberg, US Treasury 30 Year Bond Yield (orange) and WTI Crude Oil Front-Month Futures Contract (white); data as of July 7, 2017. Yields fluctuate over time.

What does it take to move assets key to EM’s prospects to significantly re-rated levels?  Generally, a step change in perceptions about macro prospects-either growth or inflation.  Across the developed market landscape, growth for individual key countries remains locked in a narrow set of outcomes.  Furthermore, we continue to experience low unemployment rates along with low inflation--witness Friday's stronger than expected aggregate job growth in the US and weaker than expected wage growth.  Given that narrow range of fundamental outcomes, central bank actions should be similarly constrained.  That argues strongly that we are unlikely to see a real step change in developed market bond pricing.

Even without a significant price move that turns EM into a negative outlier, we are not arguing that there won't be some near term turbulence.  EMD investors with significant sovereign exposure may suffer disproportionately should there be sharp ETF outflows, a phenomenon we have discussed at length in the previous weeks. EM Corporates, however, are more likely expected to out-perform, in our view.  And at the end of the period there should be a much better value proposition for those with dry powder or significant corporate exposure that can be rotated across the opportunity set. 

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.