Near-term headwinds for hard currency debt

Many factors have recently depressed the appetite for EM hard currency debt. The launch of US monetary policy normalization, the risk of hard landing in China and the commodities down trend have pushed spreads wider.

Yet, on technical considerations, EM hard currency debt an attractive investment offering spread versus Treasuries north of 400 bps (Chart 4). Net new supply (gross issuance minus coupons and redemptions) is expected to remain negative in 2016 as well, and, is, therefore supportive. Over a one year horizon, we expect positive asset class returns of around 4%, on an assumption of 10Y US Treasury widening to 2.75% and a 25bps EM spread tightening.

We like Central European credits like Hungary, Croatia and Romania as these are all commodity importers. In November, we added exposure to Malaysian quasi-sovereign 1MDB, which recovered strongly from oversold levels as debt servicing risks subsided.

The fund is underweight low-beta Latin American credits like Panama, Peru, Chile, Uruguay, as valuations are tight we expect them to exhibit higher sensitivity to US monetary policy tightening. We also dislike Lebanon which trades expensive relative to the underlying political risks. We scaled down our Venezuela overweight ahead of parliamentary elections in early December.

  

Challenging market environment for local rates but longer term prospects remain appealing

Emerging market growth underwent numerous downward revisions in 2014 and 2015. At the same time, persistent currency depreciation is likely to pressure inflation higher in most emerging economies. As a result, a number of EM central banks do not have space to ease monetary policy further.

Next to EM hard currency, EM local currency debt remains one of the most attractive fixed Income asset classes, with a yield of around 7%. The valuation of the asset class is, therefore, appealing and the high yield provides a cushion against further currency correction.

We remain cautious on many Asian local rates markets. We are underweight Thailand and Malaysia on higher sensitivity to Chinese slowdown, tight valuations and elevated political uncertainty.

We are more constructive on Brazilian local debt on attractive valuations and low probability of monetary policy tightening. The political environment remains challenging but FX reserves are high and have stabilized. We also remain positive on Russian and Indonesian local rates. Indonesia is expected to benefit from declining inflation, attractive carry, improving macro environment and renewed structural reform commitment. In Russia, we expect disinflation to trigger further rate cuts and decline in yields from currently elevated levels.