Dollar's rebound, weaker local currencies come together for emerging markets debt

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.

Sources also said the sell-off in emerging markets debt could be that these asset classes have been victims of their own success.

"We've seen a fairly big setback in emerging markets," said Brett Diment, head of emerging market debt at Aberdeen Standard Investments in London. He said it partly reflects oversubscribed new issues in bond markets that pushed spreads "to pretty tight levels."

The team is "taking this as an opportunity to selectively add some risk positions to our clients' portfolios. We could maybe see a bit more dollar strength ... but (emerging markets are) in a far better place than four or five years ago around the taper tantrum," Mr. Diment said.

And J.P. Morgan Asset Management said while rates in the U.S. are expected to hit around 3.25% by year-end, "this is manageable for EM," said Diana Kiluta Amoa, emerging markets debt portfolio manager in London. She agreed positions "had become somewhat stretched ... (and we) needed to see a little technical cleaning out."

While executives are "not advocating a wholesale load-up … perhaps the fear in U.S. rates has already been front-loaded in EM pricing, and some idiosyncratic stories could be turning around. The coming weeks, (we are looking) for good stories where valuations have been unfairly penalized," Ms. Amoa said.​

It seems institutional investors agree there are opportunities to add risk — albeit at a slower rate on the debt side than in previous quarters. Data provided by EPFR Global showed emerging markets bond strategies attracted $4 billion in net inflows for the three months ended March 31. That compares to $11.5 billion in net inflows the previous quarter, $20.6 billion in net inflows for the first quarter 2017, and a total $75.6 billion in net inflows for 2017.

Other managers are taking the sell-off as a signal to dial down risk.

Lewis Jones, lead portfolio manager EMD local currency at NN Investment Partners in New York, said, "We have grown more cautious in recent weeks as trend weakness in the dollar reversed course and EM currencies and bonds have come under pressure."

And Fidelity International's Paul Greer, London-based portfolio manager, said the rise in U.S. yields and more recently the appreciation of the dollar "are both meaningful headwinds for emerging markets debt. These developments, our expectation of a continuation of the dollar rally, and expensive valuations for EMD, are some of the key reasons why we have a cautious, defensive stance on EM debt and FX at present."

Mr. Greer said executives prefer to be underweight sovereign debt and see more value in "selective, idiosyncratic high-yield corporate debt opportunities." The manager is also long the dollar and short a basket of emerging markets currencies; and is overweight emerging markets local currency inflation-linked debt, and underweight bonds. "We feel this positioning will help to protect the fund in a scenario where the U.S. dollar continues to appreciate," Mr. Greer said.

Janus Henderson Investors also is taking a wait-and-see approach, paring risk in emerging markets local debt where executives "will see how it evolves with the dollar and U.S. rates," although there are opportunities in emerging markets credit, said Ryan Myerberg, portfolio manager in London.

"Emerging markets are most impacted by the dollar move. That's the asset class probably the most at risk." While on an unhedged basis local emerging market rates "provide materially higher carry than developed markets, that's being very quickly eroded by (emerging markets FX) depreciation," Mr. Myerberg said.

"We are very light on emerging markets today — not because we don't like EM over the medium- to long term, there are some idiosyncratic stories we do like — but we are very focused on the technical picture right now," he added.