January Emerging Markets Update

Monthly Commentary

February 20, 2019

Our outlook is largely in line with what we wrote last month (December Emerging Markets Update). Several of the headwinds that hurt Emerging Markets (EM) in 2018 have further improved. More dovish sentiment from the Fed, including the suggestion that it could stop shrinking its balance sheet sooner than expected, has driven a rally in U.S. Treasuries. In addition, we are starting to see early signs of China growth stabilizing, with current activity indicators and services PMIs1 improving, and a pickup in both infrastructure investment and property construction. As for China/U.S. trade, we believe there will be continued noise, but sentiment has improved. Our base case is for an extension in March. Tensions regarding technology trade are likely to continue for some time, but a further escalation of tariffs on goods appears unlikely in the near to intermediate term.

Both EM dollar-denominated debt and local currency debt have had a strong start to the year, up 3-4.5%. Spreads on the EMBI have tightened from wides of ~425bps to 360bps, just above longer-term averages. Flows have turned positive: EM dedicated funds (hard and local currency) have received about $13.5bn in net inflows this year, recouping over 100 percent of 2018’s outflows. EM hard currency funds, in fact, have recouped around 2x of last year’s outflows.

From here, we believe the bulk of returns are likely to be driven by carry, with some moderate spread tightening. For local currency debt, if we are correct on the dollar weakening later in the year, we could see an additional 1-2% of currency appreciation.

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