Clipping the coupon between slowdown fears and reflation hopes

Monetary policy divergence is back, as the US Fed announced quantitative tightening while other major central banks remain in QE mode.

This has important implications for duration and EM currencies. With market pricing challenging the Fed’s stance, such a disconnect could bring more volatility in the second half of the year.
Strong capital flows into EMD turned idiosyncratic sell-offs into good buy-on-the-dip opportunities during 2017’s first half. We expect flows to taper somewhat, thus we see relative value as a more important driver of excess returns going forward.
We expect EMD returns to hover around coupon as the market gyrates between reflation expectations and slowdown fears. We favor hard currency sovereign, or lower-duration corporate debt, as US dollar strength could revive in either scenario.
Investors may want to consider switching from indexing to alpha strategies to allow for a more flexible allocation within EM hard and local debt quality segments, and a dynamic duration management to accommodate US curve shifts and dollar strength.

Outlook and Strategy
Following very strong EMD returns during the first half of the year, we expect a more muted second half. According to JP Morgan data, EMD has performed extremely well year-to-date, gaining 7% for hard currency sovereigns and 11% in local markets, through June 20. These returns have not been solely carry based, as spreads compressed roughly 40 basis points in hard currency, and EM FX appreciation has contributed about 50% of the return in local markets.
The engines of strong EMD performance, a very benign global environment and EM cyclical growth recovery, are likely to lose thrust into the second half of the year. Political gridlock deflated uncertainties around the Trump policy agenda and resulted in a collapse of volatility to historical lows. This led to strong inflows into EMD and fueled the beta rally. With inflation muted, global central banks have kept up a dovish message, leading to further compression in term premia. These factors, together with accumulated Chinese stimulus and the lagged effects of the commodity price recovery, have helped EM growth accelerate to its fastest pace since 2011.
We believe there are good reasons to stay invested, as the EM carry remains attractive in a world of yield scarcity. However, we expect less of a directional market and think credit return dispersion should be more of a source of excess performance going forward. Also, while commodities’ performance has been soft in the year’s first half, we expect China tightening to pause, providing stability to EM fundamentals.
In this commentary, we examine EMD return potential under different scenarios and expect roughly 2% to 3% returns in the second half of 2017. We consider a base case that involves a slow deterioration in global financial conditions as the Fed (and the ECB) slowly remove stimulus, but also three alternative scenarios: 1) a duration/USD shock that could be triggered by re(in)flation, 2) a soft-patch if the economy decelerates as a consequence of excess tightening (policy mistake), and 3) the continuation of the current goldilocks environment.

A Goldilocks first half of the year for EMD
It has been a strong first half of the year for EMD: Local debt led the charge, delivering a strong 10.7% total return (as of June 14), while hard currency sovereigns and corporates returned 6.5% and 5.1%, respectively, as of June 20, according to JP Morgan data. Notably, such performance was accompanied alongside a significant drop in market volatility.
Exhibit 1 breaks down year-to-date EMD total returns by source and shows that performance did not only come from the high coupon offered by EMD, but also that spread tightening and currency appreciation played a crucial role in providing capital gains for hard and local currency markets, respectively. What was behind these excess returns? And, what can this tell us about the outlook for the second half of the year?
Two engines supported EMD strong performance so far this year: first, a very benign global environment, thanks to a drop in global inflation expectations and receding political uncertainty. And on the local side, economic activity in EM continued with the recovery started in 2016. Let’s take each factor one by one.

Reflation without inflation
While policymakers have been successful in reflating global economies in terms of growth and reduced deflation risks, they have not been as successful in returning inflation to consistently targeted levels. Following a short visit to around 2%, headline inflation in the US and the EU is now in decline, partially thanks to the recent fuel price declines, but also despite the ongoing reduction in labor market slack. Consequently, markets have de-priced expectations about the speed of monetary policy normalization in developed markets and long-term duration has rallied once again, providing a boost to EMD bonds. As shown in Exhibit 1, this contributed near 1.8% to hard currency sovereigns this year and about 0.6% to local markets.

Political uncertainty down, risk appetite up;
While we expected 2017 to exhibit a strong populist trend in developed markets, political gridlock in the US has deflated concerns around what a Trump presidency could mean for US policy toward trade with EM countries. In fact, the tax package is very slowly moving through Congress and there has been little done on the protectionist side despite the many campaigns threats. Moreover, market friendly candidates won the Dutch and French elections, and the Italian referendum passed without causing jitters to markets.
A benign inflation-policy outlook in the US resulted in a collapse of market volatility to historical lows and led to strong inflows that fueled the EMD beta rally. Notably cross-country return dispersion continued to compress, reaching levels not seen since 2007. We estimate that these two factors – volatility and flows- drove most of the appreciation in EM bonds and currencies so far this year, as shown in Exhibit 1 and 2.

EM cyclical recovery
After having bottomed in 1Q15, EM economies started to accelerate into the New Year. Spillovers from the accumulated stimulus in China, the lagged effect of the commodity price recovery, and some degree of monetary easing helped EM reach a strong rate of growth that likely peaked in 1Q17, the highest quarterly figure since 2011, according to our estimates (see Exhibit 3).
Following three years of consecutive deceleration, Bloomberg consensus sees EM growth at 4.7% for 2017, a 0.5% increase from the levels of 2015-16. Furthermore, over the last 30 days growth forecasts have been upgraded for 15 out of the largest 28 EM economies, in particular Mexico, Malaysia, Kazakhstan, Hungary and Poland, Notable exceptions are Venezuela (political crisis), Peru (natural disaster), Chile, South Africa and Colombia, where growth expectations have been revised lower.

The outlook for the Back Half of 2017
We believe the engines that took EM higher during the first half of the year are likely to lose thrust in the second half, leading to more muted returns going forward. This does not necessarily suggest a reversal of the gains seen year-to-date, but that the likelihood of excess returns on top of carry has shrunk, given a much narrower potential for further lifting by the forces that drove EMD higher in the first half of 2017.

Beware of quantitative tightening …
To start, global liquidity conditions could likely start tightening. Despite three rate hikes by the US Fed in the last 12 months US financial condition have gotten easier. That fact, together with tighter labor markets, has moved the Fed to communicate intentions to: 1) continue normalizing interest rates and 2) start a process of balance sheet unwinding at a faster pace than originally anticipated by investors. This adds to expectations that the ECB will soon announce further reduction in its asset purchase program. While we expect the Fed and the ECB to be extremely vigilant so that these transitions go smoothly, we might be slowly entering a period of ‘quantitative tightening’ that the bond market might have to learn to digest.

… but also a market challenge to the Fed
Given the benign inflation outlook for the US, market pricing suggests a more dovish view on inflation and risk-premia, a potential challenge to the Fed’s quantitative tightening process. Such tension comes at a time when volatility is at record lows (see Exhibit 2), thus with little room to pay further support to spread tightening or EM FX appreciation. By looking at previous volatility cycles we conclude that while low volatility environments can be quite sticky, volatilities have not tended to move out from their lows in a smooth fashion, rather, they tend to snap back when hit by a financial and/or economic shock (e.g. Fed’s surprise hike in Feb ‘94, taper-tantrum in May ‘13, Long-Term Capital Management/Russia crash in Aug ’98, or the global financial crisis in 2007). This argues for a close monitoring of markets and professional risk management.

Consolidating, yet stable fundamentals in EM
We expect the EM recovery to consolidate going forward. The external stimulus coming from the powerful combination of China easing, the rally in commodities, and very supportive global financial conditions has rolled over, suggesting the cyclical recovery in EM growth may have peaked in the first quarter. However, we expect China tightening to pause in the year’s second half providing stability for commodities and, subsequently, EM fundamentals. We expect the monetary pinch to ease going forward, and some stabilization to follow.
The first half of 2017 saw many idiosyncratic stories dominate the front page of the newspapers: corruption in Brazil, the downgrade of South Africa to sub-investment grade, the political crisis in Venezuela, and the referendum in Turkey. However, we believe the markets have adjusted to these events and are generally reflecting the risks involved.
There are some bright spots. Eastern Europe should continue to benefit by the pull of stronger-than-expected growth in core Europe, and the beneficial effects of a renewed pro-Euro stance in France and Germany. We expect EM central bank easing bias to continue, adding some domestic impulse to compensate for some external headwinds. In Mexico and Turkey growth is coming in stronger than expected, as political risk is de-priced for now.

The attractiveness of the EMD income
We expect EMD carry to continue to attract capital inflows in a world of yield scarcity. The IIF expects non-resident portfolio flows into overall EM debt to reach $183 billion in 2017, an $82 billion increase from 2016. In fact, using high-frequency and proprietary data, JPMorgan estimates that year-to-date inflows into tradeable EM fixed income funds are at $45.3 billion, the highest level for the first six months of a year in the last five years.

What’s the upside?
We expect EMD returns to reside between 2% and 3% for the remainder of the year. We expect less of a directional market (beta-driven), and credit return dispersion (alpha) is likely to play a bigger role as a source of excess performance. The rally we saw year-to-date has produced relative value opportunities that we expect will become more apparent once financial conditions consolidate and volatility retraces from current low levels. Active portfolio management, both in terms of duration and credit selection, should have fertile ground to add to benchmark returns.

We display potential EMD benchmark returns under different scenarios. Our analysis includes a Base Case which assumes a slow deterioration in global financial conditions as the Fed (+ECB) remove stimulus (QT), and three alternative scenarios: 1) a Duration/USD shock that could be triggered by re(in)flation, 2) a Soft-Patch if the economy decelerates as a consequence of excess tightening (policy mistake), and 3) the continuation of current Goldilocks environment.

What to do?
We favor hard currency sovereign, or lower-duration corporate debt, as the dollar bid could revive on either alternative scenario. We believe EM sovereigns and corporates may outperform local-currency debt in the first and second scenario of Exhibit 4, either due to USD strength, or the impact of lower commodities’ prices in the case of a soft patch. Should the current Goldilocks scenario continue, we think local markets are likely to continue to outperform.
Investors may want to consider switching from indexing to alpha strategies that can more efficiently capture the opportunities provided by a more volatile market that may likely gyrate between these alternative scenarios in the second half of the year. We believe that a more flexible allocation to local debt, between IG and HY, and a dynamic duration management to accommodate US curve shifts, provides potential to maximize excess returns for the rest of the year.

Pablo Goldberg – Managing Director, Head of Emerging Markets Fixed Income Research and Portfolio Manager – BlackRock
Sergio Trigo Paz – Managing Director, Head Emerging Markets Fixed Income – BlackRock