See beyond the short-term headwinds

EMERGING MARKET BOND STRATEGY

On a mid- to long-term perspective, we are convinced that, with yields clearly above 6%, external emerging market debt remains an attractive investment in a global fixed income context and relative to local EM debt.

Yet, we acknowledge that 2016 should be another challenging year for EM debt, at least during the first half of the year as the headwinds to the asset class – such as the continued decline in oil prices and the Chinese slowdown – are, in the short term, likely to remain. However, some risk factors could progressively dissipate, likely triggering a boost to the asset class. Indeed, the recent sell-off, combined with the mixed US macro data, have rendered a Fed funds rate hike in March highly unlikely and raised the probability of a more gradual hiking cycle. This has led to a weaker USD. Besides, Chinese policymakers have temporarily managed to stabilize the RMB with a slightly lower-than-expected loss of FX reserves.

Moreover, on technical considerations, EM debt has become very attractive, offering a spread versus Treasuries north of 485 bps, a level unseen since 2009 (Chart 6). In similar style, the current yield-to-maturity (6.60%) stands at levels that have historically attracted inflows (above 6%). Moreover, investor positioning is defensive and cash levels are generally high.

We expect credit differentiation to play an increasingly important role, favouring our relative value investment approach. Our largest overweights are in Argentina (idiosyncratic recovery story driven by political transition) and Eastern European commodity importers offering upside around near-term rating upgrades (Hungary) and structural reforms (Croatia). We have a balanced exposure to select commodity exporters, with attractive 12-month risk-adjusted returns.

More constructive on local debt

Emerging market growth has undergone numerous downward revisions in recent years. Local rates have depreciated, too, making carry attractive, yields trading around 7%. Now, however, the outlook for local rates is more positive, given the mix of soft growth, manageable and declining inflation in a number of large EM high-yielding countries and accommodative EM monetary policies. We will be looking to add local duration once we identify a more decisive turnaround in EM risks.

In this context, we tactically bought back local rates (India, Mexico, S. Africa) on a view that market corrections and USD strength have gone too far. Recent inflation data have peaked, while many central banks are maintaining an easing stance.

We remain positive on Russian and Indonesian local rates. Indonesia is expected to benefit from declining inflation, an attractive carry, improving macro environment and renewed structural reform commitment. In Russia, we expect disinflation to trigger further rate cuts and a decline in yields from currently elevated levels.

We remain cautious on Thailand and Peru on tight valuations, elevated political uncertainty and higher sensitivity to the Chinese slowdown (Thailand only).