We are in the middle of the largest sell-off in emerging market fixed income in nearly two years. How did this start and when will it end?
- In our view, the drawdown in emerging market fixed income returns this year of -6.3% (as of 25 May) from the 25 January peak, as measured using a blended JPMorgan EMFI benchmark, is best understood when broken down into three chapters.
- This dissection is important because each of the chapters has isolated a specific EMFI sub-asset class, and each has nuanced implications for our views and repositioning.
Chapter I – The VIX spike: A sell-off in spreads
The initial downdraft in hard currency emerging market fixed income occurred in early February, triggered by the spike in the VIX and other market volatility indices, and an attendant sharp fall in US stocks. This was the culmination of weeks of investor concerns over the prospect of higher global inflation triggering rising US bond yields, as well as a “whisper rumour” that the US Federal Reserve (Fed) might start raising interest rates more quickly in response.
The dam broke on 2 February after the Fed raised its forecast for the rate rises. EMFI hard currency spreads spiked higher, ending the following week 33bp higher as measured by the JPMorgan EMBI GD index. Since then, volatility has remained higher; 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 opened with the repricing extending beyond liquid sovereign bonds and into less liquid bonds, including much of the area of emerging market 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 on emerging corporate and frontier bonds, catching up with that on their liquid emerging market fixed income 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 emerging market corporate bonds as we believe that 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 2018, local currency bond markets danced to their own beat, outperforming hard currency debt by over 6%. Even as market volatility increased across asset classes and the euro began to flounder, emerging market currency valuations held up. However, the crisis of confidence inevitably spilled over into emerging market currencies, 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. Currency markets are an asset class focused on 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 in May started to reflect the effects of new US tariffs and trade war concerns, while crude oil prices moved ever higher, all supporting what has become this cycle’s commodity currency darling: the US dollar.
In our view, the repricing of ermerging market currencies may have further to go.
Depreciation/appreciation of emerging market currencies versus the US dollar year-to-date
Source: Bloomberg, BNP Paribas Asset Management, as of 01/06/2018
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 a broadly positive strategic outlook over the last 18 months on emerging market currencies, our strategic outlook is now neutral pending re-confirmation of our growth investment thesis. Tactically, we see opportunities in non-directional emerging market currency trades arising from the current environment.
Our combination of positions should help mitigate any underperformance caused by further weakness, and if we are right about relative segment valuations and current alpha potential in emerging market fixed income, we are now poised to reap active returns in a more volatile and macro-driven market.
 50% JP Morgan GBI-EM GD index and 50% JP Morgan EMBI GD index
 VIX refers to the Chicago Board Options Exchange (CBOE) Volatility index
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.