EM Debt 2017: Expect a Wide Range of Potential Outcomes
TOM BUTCHER: What does 2017 hold for fixed-income, particularly emerging markets debt?
FRAN RODILOSSO: Given a new administration in the U.S., 2017 has been framed as a year with a wide range of potential outcomes. Heading into the presidential inauguration, there was plenty of talk around such issues as trade and additional fiscal stimulus through tax cuts and infrastructure spending, and how this stimulus could affect global growth. Where the U.S. dollar is going is also a really big issue.
We agree that there is a wide range of potential outcomes in the context of the Federal Reserve’s expressed intention to raise interest rates, most likely three times this year, and because economic and political uncertainty are still quite high.
BUTCHER: Can you talk a bit more about those outcomes?
RODILOSSO: Let’s start with the “Trump trade” — which holds that economic growth will be strong and thus push interest rates and inflation higher — and what it means for the rest of 2017. In the context of emerging markets, if the markets have gotten it right so far, U.S. growth is going to pick up and inflation will rise. Both dynamics support the notion that the Fed will hike several times this year, which could bring us back to a “normal” interest-rate level.
From a fixed income investor's perspective, under this scenario you want to avoid pure duration-type trades or high-duration trades. And it could be good for credit risk — including in emerging markets, where the big risks often are trade policy and the impact of the U.S. growth picture on commodity prices. Many scenarios under the Trump trade are positive for commodity prices, which could be good for credit. In emerging markets, this means that corporate debt, particularly high yield, could do well.
EM local-currency debt is a question mark because fundamentals will be positive for emerging markets local- and developed-currency sovereign bonds, in many cases, in a higher-growth environment, but volatility in EM foreign exchange could be quite high.
Another scenario, of course, is that we have it all wrong: For whatever reason, support for the more popular policies is not there and growth doesn't follow through, and maybe the velocity of money flowing through the economy is lower than we expect. If this scenario holds, U.S. growth will disappoint and the Fed will keep rates unchanged. With bond yields having risen significantly between the day before the election and yearend, there is room for rates to come back down under the “we've-gotten-it-wrong” scenario.
Credit will likely not do as well in a lower-growth environment, and it may even pull back if commodity prices don’t strengthen. The dollar would probably weaken, so EM local-currency bonds could do better, particularly on the foreign-exchange side. You might want to be in higher-quality EM credit. Investment-grade sovereigns, for instance, could do quite well.
Our fixed income team refers to the first scenario as "lift-off" and the second as "engine failure." There also is a third scenario of "low visibility" in which we might be right or we might be wrong.
Some policies are going to be implemented; some are not. There will be much political noise and significant rhetoric on trade. That is what the third, “low visibility” scenario is all about. It means that we are not going to have full visibility in the first hundred days of the Trump administration. The market is going to be reactionary, and news driven. This might mean higher rates or it might not, but it will probably mean higher interest-rate volatility, which can make high-duration trades dangerous, particularly if you are not disciplined and react to higher rates by selling quickly.
But this might also create great buying opportunities, particularly in some of the emerging markets asset classes, which are sensitive to news and tend to be something investors sell early in a risk-off environment or if sentiment temporarily shifts to risk-off in response to headlines. We think that in a low-visibility scenario, there would be some buying opportunities in emerging markets, probably on the credit side as well as the currency side.
It is important to note that from a fundamentals point of view, emerging markets are coming off a year when they bottomed out. Fundamentals were deteriorating across the board in 2016. There were many ratings downgrades, some widening current-account deficits, etc. While this is still happening in some countries, emerging markets as a whole have bottomed. Overall EM economic growth picked back up in 2016, probably to around 3.8% at the end of the year, which exceeded most expectations, and should accelerate in 2017. In fact, the growth gap between emerging markets and developed markets expanded in 2016. So the fundamental underpinnings for emerging markets aren't necessarily as bad as some of the post-election talk that says emerging markets are a more dangerous place to be under potential shifts in U.S. policy.
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