Market Views: Fixed Income
EM debt: rich or risk?
We believe that one of the difficulties with simple arguments that emerging markets have run too fast, or whether emerging markets have much more upside, is that we are in an era where historical comparisons largely lack relevance.
Misled by history?
With $13-ish trillion in government debt trading at negative rates determing what is "risk" and what is "rich" have become exercises without comparative anchors. Nevertheless, the answers we read in Wall Street research still cling to the traditional concepts of comparisons between other periods of relative historical exuberance.
We don't have a solid metric, but we suspect that historical comparisons will lead investors astray.
Without those valuation anchors and an ability to determine with confidence overall market valuation metrics, we think that following our historically reliable indicators that have been well correlated with investor returns remains the best investment path. Those indicators remain positive.
Central banks in centre stage
The key reason for that is the stance of developed market central banks. The commitment to asset purchases remains intact by the Bank of Japan (BoJ), the European Central Bank (ECB), and the Bank of England.
With so much debt subject to purchase by a price insensitive buyer with an unlimited balance sheet, valuations seem to matter less than detecting whether those commitments flag and those central banks return to a more traditional policy framework. There is no sign of this, primarily because those policies continue to show no convincing signs of producing results in the form of growth.
The exception of course is the Federal Reserve (Fed), which continues to jawbone markets when rate hike expectations sink too low and asset prices rise too high too fast.
The past week was a good example when one governor stated that September was still possible for a rate hike, and at least one hike this year was suggested. Rate hike probabilities predictably rose, but the dollar remained relatively unaffected.
The chart below shows the last ten trading days for the dollar, without a whole lot of volatility or a meaningful trend change to stronger levels.
The dollar over the past ten days (source: Bloomberg)
We suspect that the market's sensitivity to such pronouncements is waning. The dollar remaining stable to weaker is historically a very benign environment for emerging markets. Thus we see little reason to guess that that environment will turn around in the absence of observable evidence.
Investors forget that what sent the dollar soaring from June 2014 to January 2016 and caused historically negative returns in emerging market local currency investing was the divergence between these central banks. Both the ECB and BoJ were leaning on negative interest rates and weaker currencies while the Fed was wrapping up quantitative easing and expected to begin a rate hiking cycle.
New world order for monetary policy
Today, negative interest rates have been replaced with a reliance on asset purchases--a much better tool if you are an emerging market investor--and the Fed seems unable to commit. Thus we prefer maintaining risk exposures rather than pointing towards increasingly discredited historical metrics in what is most assuredly a new world order for global monetary policy.