Emerging market valuations call for pause

Jeff takes down his recommendation on emerging market (EM) debt to “neutral" after this year's big rally. He also explains why he thinks underperforming agency mortgage-backed securities (MBS) deserve a fresh look.

The emerging market (EM) advance this year has compressed hard-currency spreads versus U.S. Treasuries to where they were before the post-U.S. election rout. In other words, EM debt prices have made a round trip.

The biggest trigger of the rally was a sobering reassessment of the likelihood and timing of U.S. stimulus under incoming President Donald Trump. This helped push down U.S. interest rates and stopped short a dollar rally that had weighed on EM assets. See the chart below.

chart-bii-fading-trump
A powerful driver in the background was reflation taking root around the world, as detailed in our Global Macro Outlook of January 2017. Global reflation supports the outlook for EM debt in the long run.

Yet a rising U.S. dollar and risks to China’s economy are challenges. Because currency risks seem to be the most pressing, we favor hard-currency over local-currency debt. We also favor short duration as part of our more cautious stance.

Our long-term view on EM assets is positive. Key is improvement in our outlook for developed market growth. Our BlackRock GPS, which incorporates big data signals to provide a handle on the economic growth outlook, shows consensus growth forecasts are still too cautious. These improving fundamentals should eventually boost EM growth.

Another positive is a rebound in Chinese economic activity. The country appears to have stabilized economic growth, leading to a rebound in commodity prices that tilt the balance for EM economies. The improvement in China has addressed market concerns over the country’s debt growth, capital outflows and a potential currency devaluation for now. Longer term, we are concerned about the rapid debt buildup and the effects of what looks to be tightening monetary policy.

Reappraising mortgages

We are upgrading our outlook on U.S. agency mortgage-backed securities (MBS) to “neutral” this month, from an “underweight” before. Valuations now better reflect the risks of rising rates, in our view, as well as the uncertainty surrounding the Federal Reserve’s (Fed’s) intentions for MBS securities held on its balance sheet. These longer-term concerns, coupled with only modest widening in spreads this year, temper our enthusiasm for MBS and prevent us from advocating an overweight position.

We see an opportunity in MBS to add income while decreasing credit risk against a backdrop of ever-tighter corporate bond spreads. We also see mortgages as having other advantages over corporate credit: They lack company-specific risks and historically have been more liquid.

To be sure, we still favor credit in a rising-rate environment as higher yields can help cushion price falls. The rapid compression in corporate bond spreads, however, dulls our enthusiasm and highlights our current preference for quality over yield.

Bottom line

The surge in EM valuations comes at a time when we believe the dollar could resume its upswing and U.S. policy uncertainty is high. Agency MBS represents an attractive tactical opportunity to move up in credit quality while maintaining income. Read more on this in my Fixed Income Market Strategy publication.

Jeffrey Rosenberg, Managing Director, is BlackRock’s Chief Investment Strategist for Fixed Income, and a regular contributor to The Blog.

Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Investing involves risks including possible loss of principal. Bond values fluctuate in price so the value of your investment can go down depending on market conditions. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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