Global Macro Mid-Year Outlook July 2017
We are bullish on EM local rates, currencies and sovereign credit for the second half of the year: We see EM as well-positioned to benefit from what we expect to remain a favourable global macro environment, with low core market yields and healthy risk appetite. Notwithstanding the strong performance of the asset class year-to-date and record inflows, we expect EM to remain in the sweet spot. We think this provides sufficient room to trade a bullish EM thesis over the next 6-8 months. In particular, we highlight attractive valuations, improving fundamentals and the possibility of structural demand for EM fixed income as key support factors. We keep our overweight stance in local rates, and move EMFX and credit to an overweight stance as well: This is clearly a beta call on the asset class, with carry the main driver of performance, followed by FX gains and a more mixed outlook for capital appreciation. While we expect return dispersion to remain low in credit, we see significant scope for active country selection and relative value as a way to generate significant alpha in local markets. It is important to note that while we are bullish for 2H17, we expect 2018 to provide a more challenging risk backdrop for EM assets and, if we are correct in our projections, valuations and positioning will also become less favourable.

Preference for local over sovereign debt: We favour local markets over sovereign credit, with the former expected to generate 5.5% additional total return in USD terms by end-2017 (1.9% from FX), compared to 3.7% in credit. We prefer high real yielders in local markets and/or countries with fundamental upside, as well as high-yielding, idiosyncratic stories in sovereign credit. We are also adding some tightly trading credits/local markets as cheap hedges. Top recommendations: In local markets, we see the best opportunities in Mexico, Poland and Indonesia. We expect South Africa and China to be the key underperformers. In sovereign credit, carry is king, with Ukraine and Argentina our top picks. We also recommend extending duration in credits such as Mexico and Indonesia and recommend select EUR-denominated bonds that would benefit from EUR strength. In CEEMEA, we like Turkey and Russia but expect South Africa to underperform. In FX, our ‘likes’ list is more diverse than in the past and includes a mix of low and high yielders. We like currencies with strong growth stories (PLN, CZK,and KRW),as well as attractive valuation stories (MYR and MXN). Where political risk is not too high, we like carry (INR and IDR).

Risk backdrop also supportive: We expect the risk environment to remain supportive, with low volatility supporting carry trades and risk assets for the remainder in 2017. Some of the key risk factors thathave made up the ‘wall of worry’ for investors have receded recently, including concerns regarding protectionism and European political risk. Easy financial conditions in the US and across DM should support carry trades.

We find EM valuations still attractive, particularly when compared to the broader fixed income universe. We view local markets as outright cheap, with yield differentials over US Treasuries currently at 420bp (GBI-EM), which is only down from 520bp in February 2016. The 12.8% EM local market rally since November 26,2016 has to be put into the context of a 7.8% loss in total return terms in the aftermath of the US election. More importantly, returning to the global cycle, EM real yields are still very high on aggregate, especially in comparison to G3real yields. This provides room for EM central banks to keep policy rates on hold or ease to support growth despite tighter policy from DM central banks. This is particularly the case for most high-yielding countries such as Brazil, Russia, Mexico and Turkey, where our economists expect inflation to decline in the next two years. This leads to our economists expecting more central banks easing than tightening monetary policy until the end of the year, which is occurring for first time since 1Q15. In addition, as we point out in Local rates: Stay bullish, our economists now expect a bit more easing than the market is currently pricing in. This provides additional support to our bullish local market thesis. High real yields not only support carry strategies, but also provide significant buffers against core market rates selling off.


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