MARKETS

Emerging market debt strategy

Mar 19, 2018

Highlights

  • EMD proved to be quite resilient to the global spike in long-term yields and equity market volatility since the start of the year. Improved fundamentals and a weakening U.S. dollar helped.
  • Will this resilience persist? We see the market likely swinging between the positive of a healthy reflationary expansion and the negative of inflation fears. We expect more sensitivity to data, relatively high volatility and the risk of some EMD repricing.
  • The virtuous cycle between strong growth and portfolio inflows into the emerging world remains alive and well. Yet it requires financial conditions to tighten only gradually and a stable-to-weaker U.S. dollar. This remains our base case.
  • We favour local markets and short-duration strategies because we see them as being more resilient to the increasingly uncertain market environment. That said, we reduced some duration hedges after the recent repricing in global yields, and increase hedges versus spreads widening as valuations tightened.

Outlook and Strategy

The narrative we presented in our 2018 Outlook is unfolding as expected. Financial markets are transitioning out of two years of a goldilocks environment characterized by strong global growth and downside inflation surprises. As inflation turns the corner, U.S. fiscal stimulus adds fuel to an economy where there is no slack; an EM-friendly reflationary environment is being challenged by rising global yields and volatility.

We review market dynamics year to date and the reasons behind EMD resilience, and we believe that EMD high yielding assets continue to be well positioned against duration headwinds brought by policy normalization in developed markets (DM). This requires that financial conditions tighten gradually, a stable-to-weaker U.S. dollar, controlled China deleveraging, and non-disruptive U.S. trade policies. While all remain our base case, we acknowledge EM valuations have tightened.

EM growth entered 2018 with strong momentum, pulled by DM and commodity prices, and improvements in key idiosyncratic stories, like Russia, South Africa, and Mexico. Capital continues flowing into the asset class, sheltering growth from tighter financial conditions. However, February showed investors can be fickle when volatility spikes, revealing heightened sensitive to inflation data, policy language and the nascent ‘quantitative tightening’ brought about by central bank balance sheet rebalancing.

We continue to favor a short duration bias for the year, but following the recent yield backup in DM, we are happy to unwind some hedges for now. As volatility stays elevated, EMD valuations have tightened; thus, we rotated our hedges towards reducing the impact of potential further spread repricing.

We continue to favor local currency debt, on the back of a weak U.S. dollar, growth-driven inflows to EM equities and local yields that we see resilient to a nascent EM tightening cycle. We believe unconstrained strategies that can use FX both as a source of return can better navigate the current environment*.

*There can be no guarantee that the investment strategy can be successful and the value of investments may go down as well as up.

Sergio Trigo Paz
Managing Director, Global Head of Emerging Markets Fixed Income
Pablo Goldberg
Managing Director, Head of Research, Emerging Markets Fixed Income and Portfolio Manager