Fixed Income

EMD Relative weekly notes

Week Ending September 15, 2017

09/18/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

A cornerstone of our approach to emerging market debt is predicated on flexibility to take advantage of the parts of the market which offer the best potential returns. In seven of the past 10 years dispersion between the three main JP Morgan emerging market debt indices indices—sovereign dollar, corporate dollar, and local currency (as represented by the EMBI Gobal Diversified, CEMBI Broad Diversified, and GBI EM Global Diversified indices respectively), has been over 8%.[1] A stagnant allocation to any one asset class has historically almost always been sub-optimal on a calendar year basis. 

This year is heading in a similar direction in terms of dispersion. The local currency index has returned 15.7% YTD as of this writing, easily besting sovereign's 9.1% return, which in turn has meaningfully out-performed EM corporate's 7.2%.

In this cycle, as in all others this decade that have been characterized by local currency out-performance, the USD has been the driver, having fallen over 10% year to date. Local currency was the best relative performer for three consecutive years from 2006-2008 as the dollar index fell nearly 19% over that period.  

Of course, none of this predicts a path for future  returns, and local currency instruments are typically volatile and difficult to value. But for those who believe the gains this year have been excessive and EMD profits should be harvested, we would note that the current level of the USD index is about 27% above that 2008 low.

Potential returns for dollar instruments can be dimensioned a little easier, as they are mainly driven by spreads to developed markets. Here we believe the market's perception of whether the era of QE and negative developed market interest rates can be "normalized" is key—see the chart below. Prior to the global financial crisis and QE, EM spreads to developed markets averaged about 225 basis points. Afterwards, spreads have averaged about 100 basis points higher—not because EM have had poor returns, but because developed market yields have collapsed thanks to central banks. If markets give up on developed rates moving back to pre-global financial crisis levels, it seems plausible to us that EM spreads could fall further.

Source: Bloomberg, Barclays, JP Morgan; data as of August 31, 2017. Yields fluctuate over time.
  
There are of course no guarantees that the twin drivers of dollar weakness and an inability to normalize rates will continue on their present course. But investors should note that both factors haven been multi-year cycles historically. Without a catalyst for reversal, global fixed income investors are, in our opinion, under-invested in emerging market debt.

[1] Source: Bloomberg. Dispersion simply refers to the spread between the highest and lowest return of the three indices. Past performance is no guarantee of future results. Actual results would vaay from those of an Index.

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.