External risks to EM have declined consistently since the beginning of the year as DM political uncertainty subsided after European elections produced market-friendly outcomes and US policies so far have not focused on extreme trade protectionism. Geopolitical tensions remain elevated, especially in regard to North Korea, but the markets appear to be shrugging off the probability of an escalating conflict. The US Fed hiked its policy rate in March and June, in line with expectations, and communicated a gradual unwinding of the Fed's balance sheet in September, re-pricing expectations of a December hike and pushing US Treasuries back into the region of 2.40%. Growth in China is maintained stable as the authorities strike a fine balance among deleveraging, reform and stimulative polices. EM growth remains solid and broad-based, in spite of the only modest rebound in energy prices so far.
We retain an overweight in Hard Currency Debt, being constructive on commodity exporters, as EM credits have decorrelated from the tepid oil-price evolution (Angola, Azerbaijan, Ecuador, Kazakhstan) and specific idiosyncratic re-rating stories like Argentina, Ukraine, Egypt and Ghana. We also have a tactical and positive view on Venezuela, given that bonds are now trading well below recovery values.
Our underweights include US treasury-sensitive credits with tight valuations such as Panama, Peru, Chile, Uruguay, the Philippines and Poland. We are also underweight South Africa, which is suffering from tight valuations, domestic political transition risks, downgrade risks, insufficient fiscal adjustment and weak growth.
Local Rates continue to benefit from limited EM inflation pressures (or outright disinflation in some markets) and accommodative EM central bank policies, although either we are approaching the end of the EM easing cycles or these have been fully priced-in in most markets. EM cyclical growth recovery is expected to continue, as most EM are still at below-potential growth.
We continue to see value in EM Local Rates and remain overweight select high-yielders that are supported by high real rates and constructive disinflation dynamics (Brazil, Colombia, Russia). We are also still overweight Mexico (anticipation of easing-cycle launch in early or mid-2018, expected decline in inflation pressures, supportive base effects in Jan-Feb 2018). However, the July 2018 general elections pose a risk and we have halved the position as a result.
We are underweight lower-yielding Local Rates markets in Asia and CEE such as Malaysia (limited value), Hungary (inflationary pressures will build up in H2 17) and the Czech Republic (continued tightening by the CNB). Finally, we hold an underweight position in Turkey on the back of rising domestic political and US Treasury risks, unbalanced growth and elevated inflation.