After the (temporary) resolution of the US debt-ceiling deadlock and government shutdown late last week, the US September payroll report this week provided a further boost to EM markets. The softer US payroll numbers have pushed UST yields lower and QE tapering expectations out further: we now expect the Fed to taper in March 2014, arguably in line with investor consensus. EM fixed income markets have been a direct beneficiary of this and have traded with a constructive tone in most places. Beyond the immediate market effect, EM economies and EM policymakers have likely been granted more breathing space for now.
Of course, the delay in QE tapering does not mean that UST will be anchored at current levels forever. In fact, our colleagues still expect the 10y UST rate to rise by about 100bp over the next year. However, such a rise seems much less damaging to total returns than the sharp move higher over the summer. For EM credit investors, for example, a 100bp yield rise over a one-year period would be almost entirely compensated by yield carry at the EM USD Aggregate index level.
Moreover, if a gradual rise in UST yields is accompanied by better growth momentum in the US and in EM, this should also mean that correlations between UST yields and EM credit spreads revert to the more typical negative relationship (ie, higher core rates mean tighter spreads, not wider spreads as happened over the summer weeks). In sum, the longer-term outlook for US Treasuries is unlikely to be a reason not to re-engage more constructively with EM credit right now.
The case for a constructive short-term outlook for EM should also be underpinned by the still-attractive valuations, despite the rally in EM assets over the past few trading sessions. Excess returns in EM credit still trail developed markets significantly, for example, across the HY and IG quality spectrum. We think that the calmer and more supportive market outlook over the next few weeks should motivate investors to look more favourably at carry opportunities and higher-yielding assets.
A selective investment approach still seems justified, however. For countries unable or unwilling to use the breathing space provided by the QE tapering delay to re-adjust economic imbalances, negative market sentiment seems likely to resurface sooner or later. Hence, we do not advocate chasing the market indiscriminately: among higher-yielding assets, we remain cautious on Ukraine and Turkey local markets, for example.
However, we have taken a more constructive view on some assets in Brazil, where we recommend being long BRL/short JPY to take advantage of modest spot appreciation potential and to earn carry. We also suggest going long select Brazilian corporate credits, which have suffered too much, in our view (such as Samarco and Brasil Foods), against a backdrop of a more bullish outlook for EM corporate credit in general.
A calmer environment for EM should also mean that on-the-run/off-the-run dislocations and liquidity premia diminish. Both in EM corporate and EM sovereign credit, some liquidity-related dislocations created during the summer sell-off have yet to fully normalize. For the former, we note that smaller-sized issues continue to trade with a historically wide premium over larger – and hence usually more liquid – issues. Within our EM top recommendations this week, we explore this theme by highlighting Gazprom ‘18s. The bond trades wide on the Gazprom curve, likely related to its off-the-run and high cash price status, and offers a good vehicle to express our constructive view on the credit.
In EM sovereigns, we have recently highlighted some on-the-run/off-the run dislocations in CE and SEE credits, with a recommendation to be long EUR-denominated bonds in Romania and a preference for Croatia’s off-the-run shorter-dated bonds rather than the on-the-run Croatia ‘23s. However, dislocations also persist on the big benchmark EM sovereign credit curves. High cash-price bonds were particularly unfavoured during the summer sell-off.
Moreover, the fear of further EM fund redemptions and the naturally more limited liquidity in off-the-run issues more generally has likely contributed to additional premia in off-the-run paper.