In our fourth quarter outlook and commentary, we noted that our constructive view on Emerging Markets was predicated upon synchronous global growth and improving EM fundamentals, and further supported by a benign Fed, muted inflation dynamics, stability in China, attractive valuations and supportive technicals. We noted that several of the major risks to our thesis included an unexpected rise in U.S. inflation, as well as changes in U.S. policy, whether trade related or geopolitical.
The strong start to the year reinforced our constructive thesis, but as we have seen, several of the tail risks have come to the forefront. The markets have been volatile due to varying factors, ranging from U.S. inflation concerns to headlines about North Korea to fears of a global trade war. During the quarter, 10-year U.S. Treasury yields sold off more than 50bps on inflation fears, before partially rallying back on U.S. growth concerns. U.S. equities ended marginally lower for the quarter, but down almost 8% from their January high, particularly on trade fears and more recently, due to a repricing of the tech sector.
Against this backdrop, Emerging Markets dollar-denominated debt has been relatively resilient; while posting negative returns (-1.12% for corporates and -1.74% for sovereigns), the asset class notably outperformed ‘safe haven’ U.S. Treasuries. But, as we anticipated at the beginning of the year, EM local currency debt was the clear outperformer, returning close to 4.5% on the back of dollar weakness.
Total Returns Across Asset Classes (Year-to-Date 2018)
Source: TCW, Bloomberg; Data as of March 31, 2018
At the time of this writing, uncertainty persists on the back
of trade fears. While the breadth and extent of U.S. trade
sanctions remain unclear, actual measures have tended to be
scaled back from initial announcements. The impact of the
measures announced thus far on Emerging Markets should
be limited. U.S. imports represent about 15% of global trade,
suggesting that the other 85% is largely insulated from U.S.
protectionism. In fact, it is possible that these tariffs will have
a negative impact on U.S. growth. For example, U.S. steel and
aluminum industries are near full capacity so tariffs would
effectively hurt domestic importers of these products, and
ultimately consumers who will have to pay more for products
made from these materials.
Looking ahead, we do expect continued noise as we head
into the U.S. midterm elections. China is likely to continue to
retaliate to U.S. tariffs on its exports by imposing trade sanctions
of its own on specific U.S. products that will cause political pain
in electoral swing states (Iowa and Florida, for example).
While we do not discount the risks of a global trade war, we
do not believe that the recent news signals a fundamental
change in the direction of Emerging Markets. The asset class
continues to benefit from a global expansion and a widening
of the EM/DM growth differential. Furthermore, the expansion
within EM has been broad-based, and domestic demand is
improving. Growth tailwinds in China – an important driver
of EM growth – are too strong, in our view, to be materially
derailed by sanctions. Most analyses to date estimate that the
direct impact of 25% U.S. tariffs on China is small – between
0.2% and 0.4%. In addition, China has ample fiscal power
to support growth, and could also ease credit and property
policies if needed. Moreover, EM countries are moving
forward to remove trade barriers. For example, the TPP was
signed, without the U.S., in March.
Importantly, Emerging Markets are in the early to middle
stages of their business cycle, after undergoing significant
adjustments from 2013-2015. EM inflation, already in the low
single digits, is likely to remain muted, particularly in the face
of negative output gaps and below-trend growth. And while
DM financial conditions are tightening, we do not see this
as derailing the EM story so long as the Fed and other DM
central banks continue at a slow and well telegraphed pace.
Indeed, a continuation of the recent sell-off in U.S. stocks
could tilt the Fed to be even more measured with rate hikes
and lead to further inflows into fixed income.
As for valuations, the combination of the rate backup and a
widening in spreads has led to average yields of close to 6% in
sovereign dollar-denominated debt. We believe this continues
to look attractive relative to developed markets debt,
particularly considering the aforementioned improvement
in EM fundamentals. Within EM, we believe the story now
appears more balanced between dollar-denominated and
local currency debt. Yields between the two have converged,
and thus the return potential between the two for the balance
of the year appears to be closer on a risk adjusted basis,
particularly in light of the significant outperformance of local
currency debt in the first quarter. We do, however, believe
that local currency debt continues to present selective
opportunities for higher returns, particularly in light of the
potential to capture currency gains. The dollar appears to have
peaked in 2017 and, while there certainly may be periods of
dollar strength from time to time, we do not see the case for
a sustained and continued dollar rally, especially considering
the fact that EM growth is outpacing U.S. growth and periods
of twin deficits in the U.S. are usually associated with dollar
weakness.
We see several important risks, including the following:
- A significant pickup in anti-trade/nationalism could
present downside risks to the markets. While a global
trade war is not our base case, there is a risk that the
aggressive use of non-traditional, and non-WTO approved
trade measures, will negatively impact growth. An
unwinding of the growth story would be negative for risk
assets, including EM. Business sentiment could also
fall due to increased policy uncertainty. Certainly EM
economies are starting from a position of strength, given
reduced current account deficits, higher FX reserves and
stronger relative growth dynamics, but in general, trade
wars are not good for anyone.
- Inflation in EM remains benign and, while it is expected
to increase slightly this year, it is starting from historically
low levels. Nonetheless, any meaningful and/or
unexpected pickup in U.S. inflation that forces the Fed to
hike more aggressively will likely weigh on fixed income
markets (not just EMD).
- This is an election-heavy year in the emerging markets,
including some of the larger index countries (Brazil and
Mexico, for example). This could contribute to heightened
volatility and present some economic growth downside
depending on outcomes.
We believe that volatility will continue in the near term, driven
more by U.S. policy rather than by EM-specific factors. We
believe that there is scope for EM to outperform developed
markets given the combination of improving fundamentals
and attractive valuations. We believe differentiation will
continue, making country allocation and security selection
decisions key to alpha generation.
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