Fixed Income

EMD Relative weekly notes

Week Ending October 5, 2018

10/08/2018

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Financial markets over the past two weeks seem to have thrown in the towel on two concepts: 1) that the US economy seems set to slow in the near term; and 2) that the end of the Fed's hiking cycle might be in sight. These developments are negative for EMD in the near term, but we think they will almost certainly hasten the time when the asset class becomes poised to outperform.

Figure 1 shows the DXY dollar index from two days prior to the Fed meeting on September 26 to October 5. Clearly, the market came away believing rate hikes justified a stronger US dollar.

Source: Bloomberg; as of October 5, 2018. Data is the DXY Dollar Index. Past performance is not a guarantee of future results.

Figure 2 shows the US 30-year bond yield over the past month--with the extremely sharp spike in yields coming shortly after the Fed chair Powell suggested "we are a long way from neutral".

Source: Bloomberg; as of October 5, 2018. Data is the UST 30-year bond. Past performance is not a guarantee of future results.

That spike steepened treasury curves and brought 10-year rates to seven-year highs. Dollar bonds everywhere must now adjust to a world where long rates are moving to a higher plateau, and EM bonds are no exception.

We continually draw comparisons between this cycle and the prior 2013-2016 cycle of strong dollar/EM underperformance.  That cycle ended when Fed chair Yellen pronounced on February 10, 2016 that the Fed was not on a "pre-set" path to return policy to normal given convulsing US equity markets. That day represented the peak in EM bond spreads and sounded the starting gun for two years of low double-digit returns for EMD investors. So while it is clear the stronger dollar and higher rates will cause some EM stress in the near-term, if and when that stress hits US equities, investors should carefully weigh that history lesson in deciding on exposure to EMD.

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.