Applying Our Playbook to EM

  • We favor emerging market (EM) to developed market (DM) assets on a brighter macro backdrop. We get granular and harness mega forces, per our playbook.
  • U.S. bond yields slumped last week on softer CPI inflation data. We think still tight labor markets will compel the Federal Reserve to hold policy tight.
  • We look to this week’s U.S. data for more signs higher policy rates are cooling production and spending. We see policy staying tight even as activity weakens.

We tapped into what proved a stealth rally in EM stocks and bonds, along with the DM stock gains this year. We still think EM assets have an edge over developed market (DM) peers in the first layer of our new playbook, the macro assessment. Inflation is cooling enough in key EMs to allow policy rate cuts. We get granular in our playbook’s second layer to find countries and sectors we like. Our third layer harnesses mega forces to capture structural shifts within EMs.

Emerging market edge

We’ve preferred EM debt to DM long-term peers for some time. We went tactically overweight EM local currency debt in March, picking up higher yields for carry and benefiting from a broadly weaker U.S. dollar plus tightening spreads this year (yellow line in chart). Higher EM yields remain attractive but tightening spreads with Treasuries (pink line) lead us to consider switching to hard currency peers typically issued in U.S. dollars (orange line). But peaking DM policy rates should support EM currencies, bolstering EM local debt for now. DM rate hikes have hit EM hard in the past, but we think they’re in a different spot now thanks to improved external balance sheets. We think that’s why we’re not seeing the EM asset volatility as in the 2013 taper tantrum. The Fed’s plan to taper bond purchases then sparked sharp EM capital outflows and currency depreciation. It’s the opposite now: capital inflows and stronger currencies are boosting returns in EM local currency bonds.