Opportunities emerge, following a turbulent first half

It’s been a challenging year so far for emerging market assets. But keep an eye out for opportunities in the second half of 2018

After reaching post-crisis tights in late 2017, emerging market (EM) spreads have widened dramatically this year, making EM debt one of the worst performing fixed income sectors year-to-date. Hard-currency EM bonds were down more than 6% through the first six months of 2018* , comparable to the rout during 2013’s Taper Tantrum.

The selloff in the first half was driven by a number of factors: first, US dollar strength put pressure on EM currencies, in particular those running current account deficits and have large US dollar debt financing requirements. At the same time, investor concern around trade disputes and the impact on global growth weighed on the asset class. There were also idiosyncratic issues around specific markets such as Turkey, and Brazil.

Looking forward, we think the repricing in hard-currency debt has made valuations more attractive for the following reasons:
1. Within credit, we believe there is a case to be made to favour Emerging Market Debt (EMD) over US credit. The graph below shows the option-adjusted spreads of hard-currency EMD and US high yield (HY) versus US Treasuries in percentage points. Spreads have tightened in HY while wider spreads in EM have made valuations more compelling.

2. In addition to valuations, strong EM fundamentals and above-trend expansion in developed markets further support the asset class. That’s why we have a small tactical EMD allocation in our actively managed iShares strategic income funds. Key risks we are watching closely are an escalation of trade disputes and further tightening of global financial conditions.

3. USD strength is, in part, a function of the Federal Reserve (Fed) raising interest rates in response to strong growth, capacity constraints and rising inflation. In its recent testimony the Fed has maintained that it will pursue a policy of ‘further gradual’ rate hikes and, in our view, this is largely priced into markets. As the business cycle ages, the Fed is more likely to pause sooner, removing a support for continued USD strength and potentially reversing the outflows from EM assets.

For more on BlackRock’s iShares strategic income funds, check out the fixed income section on our site.

iSH Blog graph Jul _2.1

*Bloomberg, as of June 30 2018. Index is JP Morgan EMBI Global Composite.

Aubrey Basdeo is a Managing Director and Head of Canadian Fixed Income for BlackRock. Aubrey is a regular contributor to the Blog in Canada

Rachel Siu is a Director and is a member of the Product Strategy team within BlackRock’s Global Fixed Income group.. Rachel is a regular contributor to the blog in Canada.

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