Wednesday, November 25th, 2015

Following the Footsteps

We start with our recommendation concerning EM bonds against all other categories of US dollar fixed income. We have been underweight or neutral ever since October 2014. Our most recent upgrade happened six weeks ago and last week the model produced its highest recommended weighting of the year, even though there has been a slight retracement this week. It’s hard for an asset class with so many links to commodities to do well when they are under pressure, and while this lasts we don’t expect EM bonds to make much progress in absolute terms. However the story is better in relative terms. US High yield is even worse affected by falling energy and commodity prices. US investment grade is not immune and US Treasuries are under pressure because of the risk that the Fed will raise rates, which is one of the reasons why the dollar is strong and commodity prices are weak.

Ordinarily we would not read much into this story, but for one relationship. We find that our EM equity recommendation typically lags our EM bond recommendation by about six to eight weeks. So if EM bonds don’t fall too much during this period of commodity weakness, it is possible that we may see a material increase in our exposure to EM equities sometime during Q1 2016. The time lag varies according to the performance of EM currencies vs the dollar, with a stronger dollar tending to extend the gap, but there is no need for precision here. The basic point is that when the risk-adjusted returns of EM bonds improve, it normally doesn’t take long for this to feed through to equities.

Of course there are risks. We still think that the copper price has further to fall (and can even imagine a low-probability disaster scenario of $3,000 per tonne). We also expect China to move towards pegging the renminbi against a basket of currencies including the yen and the euro. This could happen sometime during 2016 or 2017, although there is no evidence that the Chinese authorities have a timetable as yet. This would imply an effective devaluation against the dollar, and put pressure on other EM currencies, which would in turn suppress the dollar returns from EM equities.

However commodities are not the only reason why US investors have historically invested in EM equities. There was an earlier style, which prevailed in the 1990’s, when investors concentrated on the export-led economies of Asia and the maquiladora sector of Mexico. This may be about to become fashionable again. The positive watch-list for our All Country Global Equities model has recently featured Korea and Taiwan, and currently includes China. Depending on progress over the next few weeks, it is possible that countries such as Thailand, the Philippines and Mexico could be included for a time. The positive watch-list is designed to highlight countries which are capable of making a rapid transition from an underweight to an overweight recommendation – though of course not all of them achieve this.

A strong dollar is a necessary ingredient of this style; the only caveat is that it needs to be driven by US growth rather than EM weakness. So long as EM bonds perform well against the rest of the fixed income universe we can be reasonably confident that this risk is contained. Hopefully 2016 will be kinder to Emerging Markets than 2015.

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