Fixed Income

EMD Relative weekly notes

Week Ending March 2, 2018

03/06/2018

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

We earlier suggested that with a broader range of plausible economic outcomes, more asset price volatility should be expected. The days of straight line 2%-ish growth and nearly 2% inflation for the US seem far behind. Perhaps the biggest near-term damage of this week's "trade war" narrative--apart from the in our opinion very likely medium-term economic damage--is that this twist further enlarges the range of outcomes, on top of heightened inflation uncertainty and the new Fed chair's "over-heating" comment. Markets will wait for details, then responses from affected countries, and then further moves. So broadly unsettled conditions for markets seem assured for the near term.

Emerging market debt has the advantage, still, of paying investors an appreciably higher yield than other fixed income assets to help endure the volatility. Nominal yields for the sovereigns (as prepresented by the JP Morgan EMBI Global Diversified Index) have risen by 45 basis points year to date, while spreads to treasuries have risen 14 basis points. Given the move in US treasuries and overall asset price jitters, the spread increase has been remarkably measured. Investors interested in or invested in EM during periods where volatility picks up have to distinguish between episodes where that volatility is asset-class specific or macro driven.

In the former case, reduction or removal of EM exposures is the right thing to do--when asset class fundamentals are markedly deteriorating or specific country risks are so large contagion to other emerging markets is proceeding. In the latter case, if history is any guide emerging market valuations are such that investors are quite likely to be compensated more than in other markets for market drivers that may be inescapable except for retreating into cash.

The only exception to this framework would be if the macro driver were to produce as a by-product a meaningfully stronger driver--like the taper tantrum of 2013 and the subsequent market pricing of a hiking cycle in 2014-2015. So far there is no sign that is the case.

In fact, it might be quite the opposite. The chart below shows the last ten days of the dollar index. It shows a steady move up boosted by Tuesday's Fed comments that the market concluded paved the way for four instead of three hikes. Fair enough. But on Thursday tariff talk took the market down aggressively relative to earlier moves, and this continued Friday. For EM investors, a market thesis that deteriorating policy choices and capital outflows from the US would drive the dollar down--as this move suggests--would be additional evidence to us that EM may weather whatever turbulence is ahead in better shape than other asset classes.

Source: Bloomberg, DXY US Dollar index; data as of March 2, 2018. Past performance is not a guarantee of future results.

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.