Emerging bonds and currencies offer carry opportunities

Emerging market currencies and bonds began 2019 by rallying. Emerging currencies have gained an average of 0.7% versus the US dollar since the start of the year while the MSCI Emerging Market Index has jumped 7.3% over the same period. Going forward, emerging market debt and currencies should benefit from the search for yield.

After a difficult last quarter of 2018, this year markets turned on the Federal Reserve’s 30 January announcement that it would pause its interest rate hiking cycle. That has reduced the danger of a recession in the US triggered by a policy mistake, and risk assets reacted positively. With interest rate normalisation on hold and slowing global growth, we believe that carry strategies (borrowing at low interest rates and investing in high-yielding assets), should benefit.

The decision by the Fed is also part of a wider trend of central banks easing their policies, lessening the likelihood of emerging currencies suffering from a sudden currency sell-off.

Investors are watching for signs that the US economy may be moving toward a recession, at a time when the Fed lacks policy responses to fight it because interest rates are already so low. A survey last week of fund managers by Bank of America Merrill Lynch found the largest net overweight cash position in a decade and global equity holdings fell to their lowest since September 2016. A Reuters poll of 110 economists showed last week that they see a 25% chance of a US recession this year. Considering that fiscal stimulus will fade this year, the Fed’s pause is a sound strategy in the current tighter interest rate environment to let the global economy 'soft land'.

“We’re clearly in worse shape” to deal with another recession compared with 2008, Nobel laureate economist Paul Krugman told Bloomberg News last week. Ten years ago, there was room to cut interest rates and public debt was lower, Professor Krugman said. “And we came into the last crisis with pretty remarkable leadership… Let’s put it this way, our current Treasury Secretary is no Hank Paulson.”

In the shorter run, the single biggest threat identified by investors and economists is the US-China trade dispute. While the tension appears to be lessening ahead of a 1 March deadline to increase tariffs further, they remain difficult to forecast since the US’s willingness to reach a compromise depends on the US President, who has limited support from his political base and party for his approach. Nevertheless, we remain optimistic that an extension to the March deadline will be agreed, without an immediate rise in tariffs. In this scenario, global markets would become more optimistic about growth worldwide.

Impact on investment strategy

In this environment, we have pursued our strategy of gradually reducing risk exposure in our portfolios. Specifically, we think that emerging market equities are no longer cheap (see chart 1). The MSCI Emerging Markets Index is up by more than 7.3% year-to-date, with expectations for earnings-per-share growth of 6% for 2019. As our fundamental target value has been reached, we have sold our overweight position in emerging equities, in place since early December, and shifted risk exposure in emerging market equities into emerging market local debt.

Favouring emerging fixed income & currencies

As long as the global economy does not slow more dramatically than expected, emerging fixed income and high-yielding emerging currencies will benefit from the search for yield. Emerging debt in local currencies will benefit from more dovish emerging central banks’ policies as inflation remains muted and pressure abates thanks to the Fed’s pause.

Emerging currencies have also performed well against the US dollar (see chart 2) and we retain our bearish view for the greenback in 2019. We expect that the US’s twin deficit problem and a narrowing of US interest rates compared with the rest of the world will translate into higher US risk premia.

Indeed, we believe that high-yielding emerging currencies will benefit from the search for yield. In particular, we are bullish on the Brazilian real, the Russian ruble and to a certain extent the Mexican peso. In Brazil, structural reforms are needed to maintain a solvent state and support the recent pickup in growth. Even though this will not be an easy process due to the political opposition, we expect that the Bolsonaro administration will deliver on most promises. The Brazilian real is yet to reflect these potential positive developments, which are likely to attract significant flows, although they are already priced into the domestic equity market.

Meanwhile the Russian central bank has brought inflation under control, from 16.9% in 2015 to 5% last month. The combination of positive real rates, a credible inflation-fighting central bank and higher oil prices should all support the ruble.

Finally, the Mexican peso is a traditional proxy for emerging currencies as it is one of the most liquid currencies among its peers. Although idiosyncratic risks exist, the peso offers high interest rates in the face of slowing inflation and should benefit in an environment where investors direct flows to higher yielding assets.

Near-term opportunities

As discussed above, we have continued our gradual and opportunistic risk reduction stance. The Fed’s pause has changed the relative and absolute value proposition of a number of asset classes. This has prompted us to shift our emerging market portfolio exposure into emerging fixed income in local currencies, where we see opportunity to generate better returns in the near term and lower the overall risk exposure of our portfolios. Threats to the global outlook have not changed: the US cycle is maturing and global growth is slowing. Consequently, risk-aware investors must continue to carefully balance risk and reward as we near the end of the current cycle.

Key takeaways

• The change in Fed policy, to drop its tightening bias and show patience while being more data-dependent, has created a supportive environment for risk assets
• Global growth has been disappointing in recent months, especially in Europe, where weaker external demand along with a host of domestic factors have had a severe impact
• Some room for optimism has emerged on trade given the ongoing dialogue between the US and China. Our base case scenario is that the 1 March deadline is likely to be extended with no immediate increase in tariffs
• We continue to reduce the risk exposure of our portfolios, albeit at a slower pace given the latest developments. We have shifted our emerging market risk exposure from equities to local debt and invested some of our cash holdings into credit.