Recent performance in emerging market fixed income (EMFI)

A sell-off in three chapters

04 Jun 2018

What is going on? We are now in the midst of the largest EMFI sell-off in nearly two years. How did this start and when will it end?

  • In our view, the drawdown in EMFI returns this year of  -6.3% (as of 25 May) from the peak reached on 25 January, measured using a blended JP Morgan EMFI benchmark[1] , is best understood when broken down into three chapters.
  • This dissection is important because each of the three chapters has isolated a specific EMFI sub-asset class, and each has nuanced implications for our views and repositioning.

CHAPTER I: The VIX [2] spike

A sell-off in spreads

The initial downdraft in EMFI hard currency bonds occurred at the beginning of February, triggered by the spike in the VIX and other volatility indices, and an attendant sharp fall in US stocks. This, in turn, was the culmination of weeks of concerns among investors about the prospect of higher global inflation rates triggering rising US bond yields, as well as a “whisper rumour” that the US Federal Reserve (Fed) might accelerate the pace of interest rate hikes in response. 

The dam broke on 2 February after the Fed raised its rate hike path forecast and EMFI hard currency spreads spiked higher, ending the following week 33 basis points (bp) higher as measured by the JP Morgan EMBI GD index. Since then, we have entered an environment of permanently higher volatility; the average daily move in EMFI CDS spreads as measured by the CDX EM on the run (5-year) index is now about five times its pre-February level.

 

CHAPTER II: The liquidity crunch

A sell-off in credit

The second chapter of the sell-off was when repricing began to move beyond liquid sovereign bonds and into less liquid bonds, including much of the area of EMFI corporate credit. By late March, as volatility persisted and US yields continued rising with the 10-year Treasury approaching the 3% level, we saw the spread widening of EMFI corporate and frontier bonds catching up with that on their liquid EMFI counterparts.

To some degree this is just a pricing effect: if market-makers expect the sell-off to be temporary, they will only mark liquid instruments wider as that is where they expect trading to occur. There is also a price discovery element: little if any trading of illiquid instruments occurred at the beginning of the sell-off, but as investors became more uneasy and as outflows began, brokers reflected more accurate prices across the liquidity spectrum, and the market tumbled.

In the credit space, we maintain our exposure to a basket of EMFI corporate bonds as these provide compelling carry with limited spread duration.

 

CHAPTER III: Emerging market currency capitulation

A sell-off in currencies

For the first 15 weeks of the year, local currency markets danced to their own beat, outperforming hard currency debt by over 6%. Even as volatility increased across asset classes and the euro began to flounder, emerging market currency valuations held up and the local currency asset class seemed immune. However, the crisis of confidence inevitably spilled over into ermerging market currencies (see Exhibit 1 below), and by early May emerging market foreign exchange positioning was culled across the board.

This sell-off appears to have had a different set of determinants.

  • Firstly, European and then global emerging market economic growth data began to disappoint, particularly relative to the US. Currenciy markets are an asset class of growth and highly sensitive to small changes in perceived growth prospects.
  • Secondly, China’s data slippage and monetary policy easing took the market by surprise, reversing the strength of the renminbi.
  • Finally, international trade data prints in May started to reflect the effects of new US tariffs and trade war concerns, while oil prices moved ever higher, all supporting what has become this cycle’s commodity currency darling: the US dollar. 

The repricing lower of ermerging market currencies may have further to go.

Exhibit 1: Depreciation/appreciation of emerging market currencies versus the US Dollar year-to-date

depreciation-appreciation-of-emerging-market-currencies-versus-the-usd

Source: BNP Paribas Asset Management, Bloomberg as of 01/06/18

CURRENT OUTLOOK SUMMARY

In summary, our market outlook has changed and we are attuned to a downside shift in risk scenarios. We are not convinced that the current sell-off is over, and we have already repositioned our portfolios to reflect this view

After having had a broadly positive strategic outlook over the last 18 months on emerging market currencies we have revised our strategic outlook to neutral pending re-confirmation of our growth investment thesis. On a tactical basis we see opportunities in non-directional emerging market currency trades arising from the current environment.

Our combination of positions should help mitigate underperformance caused by any further weakness, and if we are right about relative segment valuations and current alpha potential in the EMFI asset class, we are now poised to reap active returns in a more volatile and macro-driven market. 


 

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.


[1] 50% JP Morgan GBI-EM GD Index and 50% JP Morgan EMBI GD Index

[2] VIX refers to the Chicago Board Options Exchange (CBOE) Volatility Index