EMD Relative weekly notes: Week Ending May 17, 2019
May so far has been a great month for demonstrating how the differing drivers of emerging markets debt are affecting returns, and the landscape of future returns that might be expected in the current environment.
This month investors have had modest positive returns on investment grade dollar debt—about 17 basis points across both corporate and sovereign—but flat returns for non-investment grade dollar debt. The local currency index has returned a negative 25 basis points. Those returns point to why it is so hard to presume a monolithic outcome for EMD across medium-term (measured in months or quarters) outcomes. Macro environments can affect the probability of different outcomes across different parts of the asset class, and returns will vary—often quite widely—and May has provided a microcosm of this.
Investment grade EMD seems to have reasonably bright prospects. Figure 1 below shows how the markets have migrated towards pricing in interest rate cuts. It shows the market's forecast of 2020 year-end rates, subtracting the current rate. Assuming the market is even approximately right, bonds with generous yields above treasuries relative to other asset classes, but with somewhat high (BBB) to very high (A) correlations to treasuries should be a favored destination. This is especially so in risk averse, growth-constrained macro environments—which the market has forecasted will result in a Fed pivot to cuts in the foreseeable future.
Source: Bloomberg Chart depicts the expected year-end 2020 policy rate minus the current Federal Reserve policy rate from January 1, 2018 through May 17, 2019. Performance shown reflects past performance, which is no guarantee of future results. Actual results will differ from index results.
Non-investment grade debt is less straightforward. Risk aversion almost certainly constrains return probabilities, but permissive Fed environments are historically generous to this sub-sector, as demonstrated by the two-year spread compression after Janet Yellen delayed the rate hiking cycle in February of 2016. So while trade war rhetoric has been dominant this week, one's caution should be tempered by history.
Local currency prospects are less bright in coming months, assuming no change in the broad outlook. Trade tensions likely mean the dollar rises against the CNY, Brexit tensions likely mean the dollar rises against the GBP, and residual European fears and anemic growth likely mean the dollar rises against the EUR. That environment is not conducive to EM currencies performing much better. While we could argue that the Fed rate cuts so widely anticipated would help sentiment, realistically, investors would have to see the broad dollar stabilize or fall before dedicating a meaningful portion of their risk budget to EMD local currency positions.
In our view, this mix of outcomes is not unusual for EMD, and they are often reversed when risk aversion bottoms. Over history, though, this is why dollar investors have experienced negative returns over only five of the past 23 years—and never consecutively. Thus the narrative that trade fears, or really any single macro driver, should be a cause for wholesale shedding of EMD risk, is almost never correct based on our past experience.
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.