Emerging Markets: Hard Currency Debt: Time For More Optimism

For the last few years, BCA has been negative on the emerging markets (EM) macroeconomic landscape. A combination of cyclically weak growth, structural inefficiencies, a rising U.S. dollar and a bear market in commodity prices made us very cautious about the outlook for EM assets.

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In our Global Fixed Income Strategy recommended portfolio, we expressed that EM bearishness with a below-benchmark allocation to EM hard currency bonds. Although, we have been right on our negative macroeconomic call, with EM total returns moving sideways during 2014 & 2015, our underweight strategy has underperformed quite substantially so far in 2016.

UEM hard currency sovereign and corporate bond performance has surged ahead after the global market turmoil during the first few months of the year. Significantly, credit spreads of the so-called "Fragile Five" EM countries have tightened, despite what had become a widely acknowledged gloomy EM macroeconomic consensus and the more recent global uncertainties created by the U.K. Brexit vote (Chart 1).

Chart 1

We see the potential for this market dynamic to continue, at least in the next few months. Thus, a window of opportunity has opened to become more constructive on EM fixed income, despite the longer-term structural problems in the EM world. The last few years have informed us that it will take lots of bad news globally for EM hard currency assets to underperform, especially in a "TINA" world where "There Is No Alternative" to the puny government bond yields available in the developed markets.

As the probabilities that the global economic landscape will improve are increasing, and with global central banks providing a very easy monetary backdrop and commodity markets in a more balanced state supporting higher prices, we need to reassess our positioning. Today, on a tactical basis, we are moving our allocation to EM hard currency bonds to neutral (at benchmark) from underweight. In this Special Report, we elaborate on the reasons leading to this decision.

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