Fixed Income

EMD Relative weekly notes: Week Ending April 3, 2020

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

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Baseline beliefs

Our investment thesis for emerging market debt is not predicated on near-term outcomes. Like everyone else, we expect a rise in risk appetite when virus case curves begin to bend, and when economic activity revives. What happens beyond that is what truly interests us, because we believe it will have implications for the asset class that are far reaching and long lasting.

The first aspect is how the significant policy stimulus already applied will affect emerging markets. In the first instance, it is beneficial. Figure 1 shows the decline of volatility in developed assets (bottom two charts) while EM credit default spreads and FX volatility has not been affected. We are confident that lower DM volatility will lead to the same in EM. The Fed and other central banks have done great work in this regard.

Figure 1



Source: Bloomberg. In order, the charts above depict: 1) EM CDS spreads; 2) EM FX spreads; 3) US Treasury volatility; and 4) US equity market volatility October 7, 2019 through April 3, 2020. There is no guarantee that historical trends will continue.

However, the fallout from fiscal stimulus will last indefinitely, we believe. High debt levels piled even higher with new debt will leave future growth prospects lower. As discussed last week, that should leave investors with a particular bias for higher quality names. Figure 2 shows that, despite a modest rally in spreads, EM investment grade dollar debt still offers an historical opportunity for spread compression rarely seen. Lower growth should lead to a flatter yield curve in the US, making interest rate risk benign, and potentially rewarding longer duration dollar debt with higher coupon income.

Figure 2


Source: Bloomberg. The charts above depict spreads to US Treasuries for the JPMorgan EMBI Global Investment Grade Index from January 1, 2008 through April 3, 2020. There is no guarantee that historical trends will continue.

Lower-rated debt will be stressed, but there will clearly be exceptions. Companies with operations in multiple countries, sector leaders, and those with implicit or explicit government support can pay great dividends. However, blanket exposure will likely disappoint as we expect the number of issuers falling into distress to rise above historical averages, even beyond the scope of the virus this year.

Local currency rates, on a real basis, are not offering substantial compensation for currency risk. Should the dollar eventually fall, currencies could do better and there will surely be a time when this is true on a tactical basis. However, in the coming months, a weaker currency is a valuable – and rare – lever to stabilize growth prospects for major EM economies. We see this as another challenging area to invest in with confidence.

As we come out of the present period, EM can contribute to portfolios to the extent that investors are consistent with the implications from what will have happened. Over the medium term, we believe the bifurcation in returns in this asset class is likely to be stark for extended periods.

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.