After Brexit, does EM offer a safe haven?

18 Jul 2016

Key takeaways

  • After an initial negative reaction to the Brexit result, emerging markets (EM) assets have performed extraordinarily well.
  • We estimate the direct macroeconomic impact of Brexit on EM to be weak at most.
  • EM Americas and Middle East present the strongest return opportunities given their low dependence on European demand.
  • S. interest rates pose a potential headwind for emerging markets fixed income (EMFI) assets.

Full commentary

After an initial negative reaction to the Brexit result, risk aversion subsided and most EM countries have recouped their losses. Assets were initially hit by fear, however many investors saw a chance to reallocate to EM bonds and most indices now stand significantly stronger than pre-referendum.

Britain’s vote to leave the EU has counter-intuitively accelerated investor flows into EM, by providing an escape from the uncertainty of Europe, offering both carry and underlying duration advantage. Of course the idea of EMFI acting as a “safe haven” is preposterous, but geographically EM is far from the epicenter of European political and economic risk. EM countries have limited exposure on aggregate, with EM exports to the UK accounting for just 0.6% of total EM Gross Domestic Product (GDP). EM countries with strong links to Europe will be more sensitive, as we watch over the middleterm
how this story unfolds for the rest of the EU. We believe Latin America and the Middle East regionally offer the strongest return opportunities given their low export dependence on Europe, while country spreads (over Treasuries) remain elevated coming out of the oil shock of 2014-15.

Investor insatiability for duration and credit continues to underpin hard currency technicals, especially amid a lighter expected EM issuance calendar for the remainder of the year. Despite notable compression since February, spread levels appear historically elevated and could plausibly break through to a new lower trading range in the second half of 2016. Credit curves remain steep, even after June’s reversal, and may experience normalization if flows persist. More surprisingly, EM currencies have also benefited from a tailwind, helped by a combination of the general carry trade environment and post-Brexit expectations of an extended Federal Open Market Committee (FOMC) pause.

Positive EM stories are overtaking negative EM stories on the proverbial front page. Idiosyncratic changes in news flow have become helpful at the margin. Investors have “discovered” a new market called Argentina; Brazil is on the right track again; oil prices have recovered and oil credits from Mexico to Saudi Arabia are no longer flashing warning signs. Indeed, one EM country, Russia, ostensibly benefits from Brexit, since a divided Europe is less likely to renew sanctions.

What’s missing from this rosy picture? What are the potential risks for investors? We are primarily concerned about another developed market that has counter-intuitively incentivized flows into EMFI: the U.S., and particularly interest rates. U.S. Treasury yields now stand at historically low levels, whilst asset price inflation is strong, core Personal Consumption Expenditure (PCE) prices are firm and U.S. wages are clearly accelerating. Looking forward a year from now it’s entirely possible to envision the U.S. economy on a solid footing, inflation rising, an overheating real estate market and fiscal stimulus from the new president. All of that points to the U.S. Federal Reserve hiking and would necessitate a repricing of the underlying yield curve.

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