Fixed Income

EMD Relative weekly notes

Week Ending August 18, 2017

08/23/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

This week's wobble in risk underscores again that "risk off" means something different for emerging markets (EM) in the current environment.  When emanating from developments in the US, it has not meant that the US dollar rallies as it has in past historical episodes. Instead, the dollar has been rather remarkably stable, and the DXY US Dollar index actually ended the week down about 70 basis points from its high on Tuesday when US equities were selling off.

As long as this stays the case, we feel market corrections seem very unlikely to be EM specific.  That means that a prolonged correction that follows the current pattern is unlikely to draw capital from EM, which would result in lower FX reserves and a potential negative transmission to domestic markets.  However, EM would certainly not emerge unscathed; rather, it would simply mirror to some extent the effects of risk-off in other asset classes.  We often get asked “what would happen to EM if…” (fill in the blank with a negative event); with the implication being that EM would suffer disproportionately and should therefore not be owned relative to other asset classes in whatever negative scenario is being offered.  However, this week is yet another reminder to us that this is not the way the world is currently working. 

Still, a reasonable investor will acknowledge some amount of potential returns have been well realized.  While we refrain from forecasts as much as possible, we have confidence in the view that the probability of significantly out-sized gains for local currency-only investors has likely diminished.  The virtuous cycle of the past 19 months has helped result in rate cutting cycles that have delivered generous historical gains in interest rate compression as well as currency appreciation.  

However, the rates side of that story will almost mathematically be lower in the future.  Year to date, the recent return from rates in the local currency index has been around 6.6%, just above the 6.5% return from currency.  History shows that as long as the US dollar trend is down, the probability for positive returns remains high and has the ability to out-perform other asset classes. It’s just that the size of that out-performance potential will likely be lower and the places to find the best potential returns will be less abundant.

For the rest of the opportunity set, we think dollar credit risk in the asset class remains well anchored by economic growth that continues to recover in the largest countries across the asset class.  With future local currency gains having become more muted, investors who are able will have to weigh potential outcomes in that space against solid dollar credit risk story in both sovereigns and corporates. Despite the out-sized gains for the local currency index year-to-date, a more blended approach of the opportunity set is, in our opinion, becoming much more highly probable to offer the best EMD outcome.

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.