Dovish global monetary policies helped
During 1Q the FED made a 180º turn on its communicated intentions to continue normalizing monetary conditions. The FED opted to not hike rates, lowered its own expectations of future rate hikes to one hike in 2020. As the quarter progressed, markets stopped pricing hikes in 2019. Furthermore, the UST yield curve inverted, bringing back fears that a recession was near. ECB and BOJ were consistent in keeping their accommodative monetary stance.
Lower global growth and policy uncertainty had a negative impact later in the quarter
Economic data continued to soften with some indicators taking a turn for the worse, overwhelming the positive impact of easier monetary conditions and generating bouts of risk aversion.
China stimulus starting to bite
China's growth momentum weakened further in 1Q. Weaker sentiment affected domestic demand, while the distortion generated by the imposition of tariffs by the US affected exports. With that background the National People's Congress (NPC) announced several counter cyclical financial policies aimed at supporting economic activity in 2019.
Significant inflows into EM FI in 1Q
It is usually the case that a soft backdrop in global monetary conditions increases the appeal of high yielding asset classes, including EM. EM FI attracted a solid $34.7 billion in 1Q. Sovereign and corporate credit saw inflows of $27.4 billion while local (FX and rates) attracted $7.3 billion. Furthermore, issuance from sovereign and corporate names was lower than it is usually the case, while amortization and coupon payments were substantial. As a result, the technical backdrop - in credit in particular - was very supportive of the asset class in 1Q.
Politics continue to plague EM
Argentina and Turkey were once again the main protagonists in an otherwise calmer quarter. Argentina's spreads, rates and FX rallied in January together with the rest of EM, only to sell off later reflecting the significant drop in economic activity and on the popularity of the reformist government. The October election will continue to drive market volatility in Argentina. Turkey's asset prices were also impacted by the local elections on March 30th. Markets grew increasingly nervous about the potential election outcomes, while locals dollarized their portfolios further. As a result, the currency came under severe pressure ahead of the elections, forcing the central bank to take counter measures that lifted interbank rates as high as 1,200%. In contrast, markets remained calm ahead of the presidential elections in the Ukraine on March 31st. This was because it was expected that there were not going to be any winners in the first round and that pro-west and pro-IMF program candidates were going to make it to the second round on April 21st.
Global dovishness helps EM valuations
EM FI asset prices rallied on DM central bank dovishness and on positive expectations on the resolution to the current world trade issues and China stimulus. If all of the above come to fruition, EM will benefit from the implied positive dynamics of a recovery in global growth and trade together with higher commodity prices. In spite of the great rally in credit spreads during the 1Q, we believe there are still some idiosyncratic opportunities in credit. However we believe that most of the excess returns in 2Q will come from carry rather than from price appreciation. We also highlight that corporate spreads may offer interesting opportunities in 2Q as they lagged sovereign spreads so far this year.
With very few exceptions (Argentina, Brazil, South Africa and Turkey) EM rates rallied across the board in 1Q, following the dovish global monetary stance and the significant rally in DM rates. There may be opportunities in the countries that lagged the rally because of idiosyncratic issues but generally speaking rates are at or close to fair value. Were DM rates to sell off on better economic data and/or resolution of uncertainties, EM rates could follow, detracting from performance in 2Q.
The performance of EM FX in 1Q was mixed and driven by idiosyncratic factors amidst a lack of sponsorship from the USD, which strengthened vs the Euro and on a trade weighted basis. EM FX is unlikely to rally significantly unless global risk appetite recovers and USD depreciates. If we are right and most of the current uncertainties are resolved in 2Q, then we expect FX to perform better but with high volatility driven by high event risk in DM and EM. If the situation in Argentina, Brazil, Turkey and South Africa improve, we could see significant rallies in their currencies in 2Q.
It is too cold in the world now
We started the year with a constructive stance based on cheap valuations across the board and a not-too-cold-not-too-hot baseline scenario when it comes to the global economy.
Our optimistic views were based on the following main pillars:
- Trade wars subside
- DM growth stabilizes
- Commodity prices recover and stabilize
Regarding the first condition, we still believe that there are enough incentives for both the US and China to reach an agreement given the macroeconomic and financial costs that both parties may endure in the case of an escalation. However, we also acknowledge that negotiations are likely to be tough and that further delays are possible.
Regarding the second condition, US growth slowed down as expected but European growth slowed down a lot faster than expected. This growth dynamic has had a negative impact on the Euro, limiting the expected strengthening versus the USD in 1Q.
Finally, valuations in credit are no longer as compelling as was the case in 4Q 2018 as the rally has largely priced in a benign resolution of the ongoing trade conflicts. EM rates have already rallied quite substantially almost everywhere and could get negatively impacted if DM rates sell off. EM FX is unlikely to strengthen as an asset class until risk appetite improves and USD weakens. (Federico Kaune)
Sovereign debt: What next after a strong start
Sovereign credit posted an impressive 6.95% return in 1Q (measured as JP Morgan EMBI Global Diversified), although most of the performance (4.4%) was added in January. February and March contributed as well, but increasing uncertainty and declining UST yields played a more prominente role than spread tightening. 10y UST yields declined by around 28bp while spreads tightened by 64bp in 1Q.
At around 350bp for the EMBIGD, sovereign spreads seem to offer fair value and still attractive carry for a low yielding global environment. However, a further spread tightening would require more clarity on some of the existing uncertainties: US-China trade, global monetary policy, global – and in particular China – growth rates. In this context, we expect a range-trading in USD sovereign debt, favoring a carry strategy in 2Q. Spread widening to around 400bp should trigger an increase in risk exposure. (Uta Fehm)
Corporate debt: Valuations tighten as tailwinds ease
EM corporate credit provided robust 1Q returns of 5.34% (measured as JP Morgan CEMBI Diversified) providing positive returns in each month. Corporate credit spreads tightened by 40bp this quarter providing 3.55% of the 5.34% quarterly return backed by spread tightening from both high grade and high yield, while the US interest rate rally contributed 1.73% to the quarterly return.
Value can be found in deleveraging high yield issuers, investment grade credit that has lagged the US Treasury rally, as well as new issuance. On the other hand, caution is warranted in Turkey where we expect to see continued volatility, economic slowdown, and stress on financial institutions and domestic oriented businesses. Risk appetite in emerging markets credit continues to be driven by headlines. We continue to monitor trade negotiations between the US and China, Mexico's inconsistent messages to the market, Argentina's political uncertainty in an election year, additional sanctions on Russia and political headlines in Turkey. (David Michael)
Local debt: heavy lift
EM local debt (measured by JP Morgan GBI-EM Global Diversified index) showed a 2.92% return in 1Q following a difficult 2018. The positive performance in 1Q was highly uneven, and the mirror image of the performance in 4Q: Argentina and Turkey once again underperformed on rising political risk and incomplete macro adjustment. Commodity-driven currencies shined with Chile, Colombia, Indonesia, Mexico, Peru and Russia performing well. Volatility has remained high, but without the series of large global draw-downs of 2018. The positive performance in local markets, concentrated in January, was helped by the recovery in DM equities and credit, while the rally in UST in March benefited local rates, but not currencies.
The outlook for 2Q depends on the interplay between the supportive global factors (with tail risks), and persistent political noise and/or fundamental imbalances in virtually all major EM countries. This environment warrants a positive, but cautious bias, in EM currencies and higher-yield rates for 2Q. The main risks to the outlook are stemming from weak global growth and a flaring up of political risk in EM (Igor Arsenin).