James Bevan: Emerging market interest
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Emerging Market (EM) fixed interest is one of the candidate assets that we consider both as a means of achieving decent income returns and adequate total returns, but also as a source of diversification from an ongoing weighting to UK and overseas equities.
Some commentators had assumed that as deflationary risks increased so EM fixed interest as an asset class would prosper, but instead the ongoing fall in commodities prices has led markets to fear that the outlook for global growth is deteriorating. And this has had a detrimental effect on EM markets and their assets overall.
In terms of the near term outlook for EM fixed interest pricing, the clear risk that we can see for this week is that the US Fed signals at its Wednesday Open Market Committee (FOMC) meeting that it will likely begin raising the Fed Funds rate at its September meeting.
As to what’s happening in EMs right now, most indicators suggest that the outlook for growth in EMs has recently deteriorated, with metals prices as one of the better leading indicators for EM exports having broken down to their lowest level since Q4 2009.
We also have direct survey data with China’s Caixin flash PMI unexpectedly falling sharply in July to its lowest level since April last year. Euroland PMIs are also weaker than had been expected. These surveys signal weakening growth in two of the world’s three largest markets for EM exporters.
Meanwhile falling oil prices are bad news for oil producing EMs, and given historic issuance by related companies may be particularly important to the rise in developed market high yield credit spreads, which influence EM debt pricing given that risk and value are relative as well as absolute concepts.
Against this background, the widening of EM hard and local currency sovereign spreads to Treasuries is unsurprising – but it does seem somewhat surprising that EM spreads have not broken higher and are not trading above May levels, much less Q1 levels, even as EM underperformance of developed market equities has deepened.
Most of the pain for EMs seems to have been taken in currency movements and this despite intervention from a number of leading EM central banks and stability of the CNY.
We can surmise that this reflects outflows from EM equity markets in part, but also likely a surge in hedging of local currency fixed income positions in lieu of actual position reduction.
The latter is typically the first step in market consolidation. The logical question that follows is whether investors will begin selling bonds more aggressively, to cut EM weightings, rather than just hedging through FX.
Against this background, this week’s US data and events will be crucial.
If pushed on what to expect from the 28th-29th July FOMC meeting, we look for the Fed to signal that it intends to begin raising the Fed Funds rate in September.
We suspect that in the current environment this would be negative for EM markets, in and of itself. Potentially offsetting this slightly, the GDP numbers out on Thursday (today) could positively surprise given the part data releases to date.
