In our base case scenario of muddle-through growth, with a gradual recovery of EM growth alpha and moderately tighter financial conditions, we prefer to base our core exposures on higher quality credit names with stronger balance sheets and fiscally prudent positions. This reflects our more cautious longer-term view, given the still- considerable downside structural risks from commodities, China and U.S. monetary policy normalisation. For the second quarter, however, the prospect of lower market volatility and a cyclical stabilisation leads us to favour tactical positions in idiosyncratic high yield stories.
From a sector perspective, we remain constructive on duration, as the challenging growth backdrop, global easing bias, currency stability and generally moderate inflation dynamics should continue to support local currency rates. While yields have rallied this past quarter, we still believe there is further room for compression.
China’s economic transition from investment-driven growth towards a more sustainable market-based model focused on services and consumption appears to be well underway. However, achieving a smooth transition is being made more challenging by several structural obstacles.
In this paper, Emerging Market Debt portfolio managers Ai Ling Ngiam and Derek Traynor look at some of these structural issues, focusing on how excessive levels of leverage and industrial overcapacity have the potential to derail China’s economic transition. We also examine how China’s capital account is coming under pressure as the country embarks on a programme to liberalise its exchange rate regime.
Market confidence has been badly hurt in the opening weeks of the year as investors worry about the possibility of a global recession. We believe these fears are probably overdone and investors should take a step back and look at the big picture, particularly in the eurozone.
The eurozone saw moderate economic growth in 2015 of around 1.5%, and we see several reasons why this momentum should be sustained this year, including further support from the European Central Bank (ECB), more supportive fiscal policy and cheaper energy.
Some European sectors and companies will be negatively affected by weakness in global trade and the slowdown in China and other emerging markets. On balance, however, we believe that the domestic drivers for eurozone growth can offset these negatives. In this note we briefly outline those positive forces and restate the case for active investors to retain their exposure to regional risk assets.
We think emerging market debt will be driven more by idiosyncratic alpha than broad market beta in 2016 and, therefore, country differentiation will be crucial to seek out the best alpha opportunities:
What summarizes the EM struggle right now is this: increasingly cheap valuations, and the potential for higher reward, juxtaposed against what we might call the summary statistic of all the headwinds weighing on emerging markets: a de minimis growth premium relative to what we’ve seen historically vs. the developed world and unfolding risks from Fed policy and China FX intentions hence higher risk, higher (potential) reward.
To what extent are national and regional economies engines of global growth, and what causes economies to move together? We examine the drivers of business cycle synchronization and cast today’s experience—that developed market (DM) economies appear to be out of sync with one another and with emerging market (EM) economies—in historical relief.
We find that, outside of recessions, DM divergence is a normal state of affairs. We also find that in stark contrast to growth, DM bond yields display a very high degree of co-movement. Since only part of the relationship among bond yields can be accounted for by underlying fundamentals, we ascribe an important role to financial globalization in tying markets together tighter than economies.
Relatively weak links among DM economies and between developing and emerging economies suggest that “global engine” stories should be taken with a pinch of salt. Changes in financial conditions arising from economic divergence, such as changing relative interest rates and exchange rates, appear to act as only loose constraints on economic outcomes. As a result, the effect of financial spillovers may well turn out to be more subtle than many people fear.
Meanwhile, financial synchronization indicates that DM economies import financial conditions from one another as they move through the business cycle, creating slightly looser conditions for vanguard economies and slightly tighter ones for lagging economies.
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