The strong dollar, weakness in local currency markets and country-specific challenges in emerging markets are coming together to create excitement for some active money managers.
After a number of challenging years for this set of countries, including the 2013 so-called taper tantrum attributed to comments by then-Federal Reserve chairman Ben Bernanke, emerging markets debt looked to be back on track.
The Bloomberg Barclays EM USD Aggregate Total Return Index Value Unhedged gained 8.17% in 2017 and produced positive returns for the years 2014, 2015 and 2016. In 2013 the index lost 4.12%.
But for the year to May 22, fixed-income returns have been -3.63%.
Sources cited a strengthening dollar in 2018, compared with a weak dollar in 2017; rising interest rates in the U.S.; and some difficult stories across emerging markets countries as reasons for the difficulties. Some money management executives are taking emerging markets weakness as a signal to dial down risk, while others are picking over debt markets to find opportunities and add to their positions.
"It's fair to say that the headwinds around emerging markets are a lot more challenging than last year, and coming together with a lot of bottom-up country stories," said Tim Ash, emerging markets senior sovereign strategist at BlueBay Asset Management LLP in London. "Last year was very much an EM goldilocks scenario … if you think about the legs for EM last year (there was) synchronized global growth, eased concerns about China, high commodity prices, a weak dollar and gradual Fed tightening.
"This year things look more shaky — a strong dollar, Fed hiking expectations (becoming more aggressive and) more focus on EM leverage,'' Mr. Ash said. "This year in any event for me, it is about EM country alpha. There is a huge number of EM country stories, lots of elections (and) tricky situations."
While executives are not panicking over changes in emerging markets, they are "mindful that there are a lot more risks both top-down and bottom-up, but there are still ... some good country stories."
Other money managers see a more enticing playing field for active managers in emerging markets.
L. Bryan Carter, head of emerging markets fixed income at BNP Paribas Asset Management in London, said the firm views the debt sell-off story in three chapters, "and each chapter has hit the asset class in a different way." A February sell-off was about volatility and spreads, while in April the sell-off spread to less liquid bonds. The current, third chapter, is a "currency capitulation," he said.
While the U.S. dollar has been a theme throughout, now "it's about EM. Suddenly in the past three or four weeks the data for EM has really turned — now we're seeing China is not so strong, a slowdown in core Europe ... having a knock-on effect in Eastern Europe, and trade data,'' he said. "The dive we've seen the last two weeks or so in leading trade indicators, especially for Asia, all paint a pretty worrying picture for the sustainability of the growth thesis in EM."
The drop in some emerging markets currencies' values against the dollar makes sense, although this is also an idiosyncratic story, Mr. Carter added.
The Argentine peso hit a low point this month, trading at 4.05 cents May 15, compared with a high of 5.4 cents Jan. 3. The Turkish lira's low point was 2.16 cents May 22, compared with a high of 2.67 cents Jan. 7.
BNP Paribas' debt team has made changes to its holdings. It held a directional emerging markets FX overweight for 18 months, and has now moved neutral.
But at the same time, Mr. Carter said the team has increased the alpha risk budget.
"It's incredibly idiosyncratic. We usually don't have this much dispersion in a sell-off — usually correlations go to one, as they say. We're seeing a really nice alpha playground as we look around the world," he said.