Emerging markets debt strategy

Clipping the coupon

04 jul 2017

Highlights

Monetary policy divergence is back, as the U.S. Fed announced quantitative tightening while other major central banks remain in QE mode. This has important implications for duration and EM currencies. With market pricing challenging the Fed’s stance, such a disconnect could bring more volatility in the second half of the year.

Strong capital flows into EMD turned idiosyncratic sell-offs into good buy-on-the-dip opportunities during 2017’s first half. We expect flows to taper somewhat, thus we see relative value as a more important driver of excess returns going forward. We expect EMD returns to hover around coupon as the market gyrates between reflation expectations and slowdown fears. We favor hard currency sovereign, or lower-duration corporate debt, as U.S. dollar strength could revive in either scenario. Investors may want to consider switching from indexing to alpha strategies to allow for a more flexible allocation within EM hard and local debt quality segments, and a dynamic duration management to accommodate U.S. curve shifts and dollar strength.

Outlook and strategy

Following very strong EMD returns during the first half of the year, we expect a more muted second half. According to JP Morgan data, EMD has performed extremely well year-to-date, gaining 7% for hard currency sovereigns and 11% in local markets, through June 20. These returns have not been solely carry based, as spreads compressed roughly 40 basis points in hard currency, and EM FX appreciation has contributed about 50% of the return in local markets.

The engines of strong EMD performance, a very benign global environment and EM cyclical growth recovery, are likely to lose thrust into the second half of the year. Political gridlock deflated uncertainties around the Trump policy agenda and resulted in a collapse of volatility to historical lows. This led to strong inflows into EMD and fueled the beta rally. With inflation muted, global central banks have kept up a dovish message, leading to further compression in term premia. These factors, together with accumulated Chinese stimulus and the lagged effects of the commodity price recovery, have helped EM growth accelerate to its fastest pace since 2011.

We believe there are good reasons to stay invested, as the EM carry remains attractive in a world of yield scarcity. However, we expect less of a directional market and think credit return dispersion should be more of a source of excess performance going forward. Also, while commodities’ performance has been soft in the year’s first half, we expect China tightening to pause, providing stability to EM fundamentals.

In this commentary, we examine EMD return potential under different scenarios and expect roughly 2% to 3% returns in the second half of 2017. We consider a base case that involves a slow deterioration in global financial conditions as the Fed (and the ECB) slowly remove stimulus, but also three alternative scenarios: 1) a duration/USD shock that could be triggered by re(in)flation, 2) a soft-patch if the economy decelerates as a consequence of excess tightening (policy mistake), and 3) the continuation of the current goldilocks environment.

Pablo Goldberg
Managing Director, Portfolio Manager and Senior Strategist for BlackRock's Emerging Market Debt Team
Sergio Trigo Paz
Managing Director, is Head of BlackRock’s Emerging Markets Debt Team