Fixed Income

EMD Relative weekly notes

Week Ending February 9, 2018


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Humans cannot predict future asset prices. When asset prices trend in fairly narrow ranges in a seemingly predictable manner, the level of confidence that tomorrow will be roughly like today rises, infusing participants with an unwarranted level of confidence. When that path is broken, more appropriate levels of humility emerge.That emergence of humility is also known as volatility. It necessitates prudence in risk-taking.

We believe we have moved from a regime where real economic outcomes were narrow—growth and inflation would be modest and in a narrow range while economic policy would be well signaled and predictable—to one where real economic outcomes seem much wider. Fiscal policy has turned from a non-factor to significantly stimulative at the exact same time that inflation fears, which for so long were a disappointment, now have some modest confirmation. That combination promises more restrictive future monetary policy in less predictable ways. It also brings forward the probability that the Fed will raise rates until something breaks. Thus, the path of potential economic outcomes has widened—making humility (volatility) the only appropriate response.

For emerging market debt investors, this regime change need not be cycle changing in the sense of reversing liquidity flows that change economic outcomes from positive to negative. Certainly near term asset prices will we believe fall, but we are more focused on looking for signs that historically have correlated with that shift in liquidity flows. We don’t see them—currencies are not overly appreciated and external deficits are not overly large.

Most importantly we don’t yet see a rationale for the dollar to rise significantly. US external and fiscal deficits are rising towards poorly-run emerging market levels. That does not bode well for liquidity flows to reverse into the US even if rates rise. Without the catalyst of a rising dollar, emerging market assets will follow those of other markets in their reflection of fear, but they are unlikely to under-perform them meaningfully, in our view—that has been historically documented. So for investors in this asset class, we believe humility is appropriate, but fleeing may not be as appropriate.

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.