After Brexit, do emerging markets offer a safe haven?

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• 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.

• U.S. interest rates pose a potential headwind for emerging markets fixed income (EMFI) assets.

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 middle-term 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.

Exhibit 1: Following Brexit, emerging market assets have performed well – the graph below highlights the calmer situation – emerging-market share volatility has declined post-Brexit (the graph shows the CBOE Emerging market ETF volatility index for the period from 01 June 2016 through 25 July 2016)

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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. [divider] [/divider]

This article was written by L. Bryan Carter, head of emerging market debt, in New York on 19/07/2016

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, portfolio transaction, liquidation and custody services for funds invested in emerging markets may carry greater risk.

L. Bryan Carter

Head of Emerging Markets Fixed Income

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