EMD Relative weekly notes: Week Ending May 3, 2019
Emerging market debt is an asset class where analysis based on superficial impressions can be significantly misleading. Current market conditions illustrate how different parts of the opportunity set offer a varying probability of positive outcomes.
Most broadly, positive conditions—like a Fed “on hold” versus steady hiking expectations—can lead to generous returns as all parts of the asset class rally. Since November, which marked the end of a prolonged US dollar rally and the start of markets adjusting to a more dovish Fed, sovereign dollar bonds have returned 7.68% and local currency has returned 6.98%—remarkably similar to the uniformly positive outcome in 2016 when the Fed also shifted course dovishly and all parts of the asset class returned just under 10%.
However, significant dispersion is occurring, and is likely to continue. Within local currency, the Fed has helped but the continued dispersion in economic performance between the US and Europe—which after this week's data seems set to continue—has made part of the index a poor bet. A full 20% of the index—Romania, Hungary, Poland and Czech Republic—has an 85% correlation to the Euro. This segment has produced year-to-date negative returns even though the index is up 3%. Figure 1 shows the steady decline in the Euro during that period, with lower highs during rallies and lower lows during sell-offs. So, 20% of local currency currently has poor prospects despite the stronger trend across the rest of the index.
Source: Bloomberg. Chart depicts the EUR Euro Spot Index from January 1, 2019 through May 3, 2019. Performance shown reflects past performance, which is no guarantee of future results. Actual results will differ from index results.
Within the EMD dollar space, 14.7% of the blended sovereign/corporate index is rated single-A with a more-than-80% correlation to Treasuries (for the ten-year period). Following the Fed meeting this week, this is an area that could also soften. It seems reasonably clear the market's pricing in of a rate cut within the next nine months may have been premature, and duration-sensitive bonds will have to adjust as that gets priced out of markets. Here EM corporates and sovereigns have produced returns of 4.25% and 4.27%, respectively.
However, a Fed “on hold” and positive risk sentiment would leave lower-rated debt with still positive prospects, in our opinion. If so, broad returns could continue to be misleading, while much of the asset class continues to out-perform the rest of global fixed income.
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.