20 FEB

2017

Fixed Income , Topics

Risk premiums on external debt have more than recovered since the US elections

Emerging Market Debt Strategy

External risks to EM remain high due to the considerable uncertainty surrounding the impact of the new US administration's policies and Brexit on EM. EM started the period with strong fundamentals, as the main risks to the asset class – Chinese economic slowdown and commodity rout - have declined over the past 18 months and growth is recovering across EM. We are still overweight on External Debt, given our positive view on commodities and oil in particular and specific idiosyncratic re-rating stories like Argentina.

Risk premiums on external debt have more than recovered since the US elections

EMD HC risk premiums have more than recovered from the surprise result of the US presidential election. EMD offers no value on an absolute basis - at 317bps, EM spreads are trading inside the 5Y average of 337bps but relative valuation to DM HY and IG still offers value, especially in the single and double B rating buckets.

In the near term, technical factors are neutral to positive, as EM sovereign supply is manageable and met by the large coupons and redemptions in Q1. YTD asset class flows are positive and we expect $20-40bn in asset class inflows in 2017.

Against this backdrop, we are maintaining an overweight position in high yielders with idiosyncratic drivers such as Argentina and Ghana, as well as select Eastern European credits such as Bulgaria and Montenegro, where valuations are attractive. We added to our overweight allocation in the energy complex with our overweight positions in countries like Venezuela, Angola, Gabon, Azerbaijan and Kazakhstan, as we expect oil prices to recover in 2017 following the OPEC agreement in November 2016 that resulted in production cuts.

Our underweights include low beta, US treasury sensitive credits with tight valuations such as Panama, Peru, Chile, Uruguay, Philippines, and Poland. We also plan to hold a low exposure to certain Middle East and North African countries such as Lebanon, which suffers from high political risk and less supportive technicals, and Oman, where supply risk is present.

Local curves: Still an attractive asset class, selective approach

Local Rates will continue benefitting from EM disinflation and accommodative EM central bank policies, although easing cycles might be shallower than expected prior to the US elections. The EM cyclical growth recovery is also expected to continue as most EM are still at below potential growth.

Consequently, we maintain our overweight to high yielders supported by high real rates and constructive disinflation dynamics such as in Brazil, Colombia and Russia. Accommodative monetary policies in emerging and developed markets favour exposure to the mid and long end of the curves.

We also overweight mid beta countries like South Africa and Mexico that have underperformed materially and have priced in most political risks. We are alos positive on low yielders such as Poland (versus the German Bunds as the spread is at extremes levels).

On the other hand, we are underweight on Asian low yielders such as Thailand and Malaysia, as well as Central and Eastern European low-yielders such as Poland, Hungary and Romania which exhibit high US Treasury sensitivity and tight valuations.