Fixed Income

EMD Relative weekly notes: Week Ending May 10, 2019

05/13/2019

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Trade Wars and EMD

A quick glance at recent equity returns is enough to conclude that trade wars are negative for virtually all asset classes not recognized as safe havens. Of course, emerging market debt is no different. However, there is a prevalent perception that because China growth would be negatively impacted by an extended period of trade tensions that broader EM will suffer disproportionately. That is not necessarily the case, and under certain conditions some parts of the asset class could outperform.

We believe the broad assumption that global growth will slow under extended tensions, with the US and China most affected, are probably correct and that markets will price those deteriorating prospects in accordingly. If true, much of EMD, along with most other asset classes, would be negatively affected.

However the roughly 15% of EMD with a high correlation to Treasuries—single A bonds—will do well, we feel, under a scenario where bonds broadly rally even if spreads to the developed world go a bit wider. Month to date, this segment has returned a positive 35 basis points. The rest of the investment grade universe—the bulk of dollar debt indices—would likely perform less well but not terribly given still high correlations to UST. Indeed, BBB-rated bonds returned a slightly negative 11 basis point drop so far this month. In total, that accounts for over half of both the sovereign and corporate indices. Therefore, if history is any guide, this is not an exposure that investors should jettison even under negative assumptions about the future.

The non-investment grade rated space would do worse, and here we see negative returns of around 38 basis points month to date. Should investors prefer to hold this part of an asset allocation, given current 8% yields, rather than other more highly price-inflated parts of their portfolio? We think yes, given the high transaction costs associated with trying to time entries and exits—though we are under no illusions that in the very short term as equities correct, risks of some price falls here are high.

In local currency any outlook is murkier. This is the most volatile part of the asset class, and over brief market periods investors might tend to shed FX risk in a negative environment.  

However, if the market begins to price in lower US growth with an extended period of hurtful tariffs, the USD could soften somewhat if that leads to a conclusion that Fed rate cut probabilities are rising. The very early returns suggest that this dynamic could be playing out. Figure 1 shows the last seven days of the dollar index—from two days prior to the tariff threats through mid-day Friday. Clearly if there is any directionality it is lower. Historically that is good news for emerging market investors across both dollar and local currency assets.

Figure 1

EMD-Weekly-Blog-5.13.2019.jpg

Source: Bloomberg. Chart depicts the DXY US Dollar Spot Index from May 1, 2019 through May 10, 2019. Performance shown reflects past performance, which is no guarantee of future results. Actual results will differ from index results.

For these reasons we believe that although EMD risk might get nicked in the current trade war scenario—which to us seems to portend signs of being a prolonged period of stalemate—parts of the asset class have the potential to outperform similarly-affected asset classes.

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.