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Emerging debt: the appreciation of the dollar is a limited threat

The essential

Emerging debt remains an attractive asset class, despite high currency volatility.

The likelihood of a significant rise in US long rates seems limited in our opinion, given the current direction of European monetary policy, the rise in the dollar and the risks associated with the slowdown in China. Against this backdrop, emerging debt offers opportunities, both via greater dispersion within the dollar-denominated sovereign debt universe or in terms of carry for sovereign debt in local currencies.

Emerging debt remains an attractive asset class, despite high currency volatility. The likelihood of a significant rise in US long rates seems limited in our opinion, given the current direction of European monetary policy, the rise in the dollar and the risks associated with the slowdown in China. Against this backdrop, emerging debt offers opportunities, both via greater dispersion within the dollar-denominated sovereign debt universe or in terms of carry for sovereign debt in local currencies.

Emerging currencies are the recipient all of the current concerns

September was a particularly difficult month for emerging currencies, which depreciated by an average of 3% against the dollar. The Brazilian real posted the steepest decline, losing 10%. This is a more specific trend caused by a highly electorate-focused presidential campaign that is seeking to minimise the efforts that will be required of Brazilians in the future. The main factor at work behind this volatility surge has been the prospect of a balance-sheet expansion, or perhaps even a quantitative easing programme from the ECB. The dollar has soared against all currencies causing, almost by an automatic effect on demand, a drop in commodity prices and a destabilisation of inflation expectations in high-inflation emerging economies. As such, a resurgence in inflationary tensions is now being priced in by investors as an inevitable consequence of a substantial depreciation of these economies’ currencies. In addition to investors’ uneasiness with regard to the Fed, the news coming out of China points towards a domestic slowdown: imports were down 2.5% year-on-year in August and gross fixed capital formation continues to deteriorate. It now stands at 16.5% year-on-year compared to an average of 27% between 2005 and 2011. Now, it is a recurrence of last summer’s shock that seems to be haunting the markets. Investor jitters are mainly over the risk of a sharp rise in US long rates. We witnessed a bear-flattening through the short end of the US rate curve. Investors are asking questions about the consequences of an impending “bear-steepening” of the long end.

Neither the ECB nor the deterioration of credit quality in China support the hypothesis of a rise in US long rates

Emerging assets exposure to US rates risk can vary substantially from one asset to another. A simple comparison of curve’s movements en emerging countries in September would be enough to convince investors of that1. On top of this, a rise in long term rates in the US does not seem the most likely scenario to us, for several reasons, other than the still less than impressive growth outlook.

Firstly, consequences of Fed policy normalisation are that straight forward as it might seem. The normalization process will affect not only both long term growth and inflation expectations but also market perceptions about the US Treasuries intrinsic risk. That said, we observe that market expectations of US long term rates, measured through forward rates, remain surprisingly low. It is not only about the extension of the current regime of co-movement between the term premium and forward rates. Over the past year, expectations for European short rates – measured by one year forwards rates – have reached an historically high correlation level of 0.85 with long rates in the United States. A plausible explanation could be that investors are able to accommodate a gradual normalisation of rates in the United States as far as the main source of price instability – deflationary tensions in Europe – is efficiently handled.

Secondly, the rise in the dollar is disinflationary due to the decline in commodity prices that it causes. Finally, if credit risk in China is to further deteriorate, the challenge to price it in a context of shortage of historical data at balance sheet levels for the main banking and corporate entities should encourage authorities as well as private investors to increase their exposure to risk-free assets. Since it is possible to talk about a quasi-peg to the dollar in the case of the Chinese currency, public and private demand for Treasury bonds is expected to remain substantial.

Carrying local emerging debt is barely more risky from the point of view of the currency than carrying debt assets in the most volatile G10 currencies.

Then, what could this mean for emerging debt assets? Upside pressure on the spread of the EMBI Global Diversifi ed of dollar-denominated debt index, even though the rise in US long rates remains limited. For the most part, this increase will refl ect greater dispersion, notably within economies in transition (see our breakdown of emerging economies by type in Cross-Asset No.9 “A global approach to emerging markets typology”, due to infl ation dynamics still poorly managed at this stage. Ultimately, this probably means a much less bright expected return compared to the current cumulative performance2, but a greater number of opportunities within this investment universe.

Against all expectations, sovereign debt in local currencies could be better positioned. The yield on the GBI-EM Global Diversified index is highly sensitive to emerging currency excess volatility i.e. their volatility gap with G10 currencies. This point is critical. In the past, the yield on this index has always been highly sensitive to emerging currency volatility. Low volatility is, above all, synonymous with appreciation of emerging currencies against reserve currencies. Since tapering was announced, the sensitivity of this yield has increased against emerging currency excess volatility. The underlying rationale behind this change is strong. It highlights that investors accept higher volatility in G7 currencies as a result of desynchronization among main central banks. Yet, this sensitivity is also an indication that the appeal of emerging currencies resides in their ability to be little influenced by the potential divergences between central banks, particularly in the G4. On this point, the best news at the moment is that volatility expectations for both advanced and emerging currencies, measured by implied volatility, are converging. In other words, carrying local emerging debt is barely riskier from a currency standpoint than carrying debt assets in the most volatile G10 currencies such as the Australian or New Zealand dollars. In the short term, currency and equity markets volatility is being fuelled by a reassessment of the global growth outlook. In the absence of signs of stabilisation, volatility may remain high, but barely above that of the G10 currencies. At equivalent volatility level, we estimate that the yield on the GBIM Global Diversified local debt index should reach 6.4%, some 35 bp below the current yield, which should lead to a positive duration effect of around 200 bp to be added to a current carry of 6.7%. it should be seen as attractive.

1 The quasi-advanced economies such as Mexico, Poland, the Czech Republic, Israel and Korea have relatively low exposure. Only the Mexican curve witnessed a 20 bp shift, while the Korean curve dropped 20 to 30 bp on all maturities. The most fragile economies, however, witnessed more substantial curve shifts: 20 to 40 bp on the South African curve, 60 bp for the Turkish curve and 100 bp for the Brazilian curve.

2 Supposing that the EMBI index`s 12-month spread reached 390 bp, the current carry of 3.4% would be insufficient to curb an estimated negative duration effect of -4.8&. In fact, the average performance of dollar-denominated sovereign debt could be lower than that of US Treasury bonds.

 

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A rise of US long term rates is not the most likely scenario

 

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Against all expectations, sovereign debt in local currencies could be better positioned

 

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Marc-Ali BEN ABDALLAH, Senior Analyst, Investment Solutions
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Emerging debt: the appreciation of the dollar is a limited threat
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