The strong rebound in EM fixed income during March likely has room to continue, but we recommend adding risk only selectively. In line with other fixed income asset classes, EM has benefited from a combination of an easing of political tensions along with rangebound US Treasuries, an ECB more concerned with low inflation, expectations that the BoJ may ease again this year, and the onset of a “mini-stimulus” round in China. We are approaching year-end targets in many fixed income asset classes, and our key concern across all fixed income markets is valuations.
EMBIG spreads are now 12bp below January 1 levels, trading at 315bp, while CEMBI spreads at 319bp are trading through our year-end target of 325bp. Even EM FX has fully retraced the January sell-off, and EM equities have outperformed DM equities during the month of March, returning 3.3%. We keep our year-end spread target for the CEMBI at 325bp given the 13% weighting for Russian corporate bonds in the index. While this EM relief rally may have further to run as low volatility in core markets is reigniting the appetite for carry trades, we warn that little has changed in the underlying fundamental picture for EM growth. The common drivers related to the US data flow and the outlook for Fed moves will likely come back to the fore at some point.
Keep marketweight EMBIG and CEMBI overall as spreads are inside of January 1 levels, while EM growth risks remain to the downside and political tensions in key countries may again escalate. In the EMBIG Model Portfolio, shift recommendations within high spread and NEXGEM markets moving Argentina and Honduras overweight, taking profits on overweights in Angola, Sri Lanka and its savings bank (NSBLK) to marketweight, and moving Pakistan underweight. In core positions, we stay overweight Venezuela, Turkey, Indonesia and Hungary, versus underweight South Africa, Croatia, and China risk (through China Development Bank). Meanwhile, in EM corporates hold core Latam recommendations but add selective Brazilian HY. In Asia, favor lower beta credits in China, fundamentally solid real estate credits, and select higher-yielding names. Hold short-dated Ukrainian credit; limit Russia exposure to cheap banks and corporates less affected by political risks.
We expect extended gains for high-yielding local markets in EM Asia and Latin America, but fade the rally in EMEA EM. The top performers in EM local markets over the past month have been the high yielders in Latin America and the markets in EMEA which previously had suffered the most from political drags. Though many pitfalls for EM local markets remain, we continue to see upside in high-yielding markets where domestic developments are also supportive at least from a near-term perspective. Stay long India and Indonesia in FX and rates, while expecting more near-term weakness in CNY. In Latin America, OW Brazil and Colombia local bonds and stay short USD/COP, maintain UW PEN as a partial hedge to a potential flare up of China concerns. With inflows to EM tentatively picking up, we fade the rally only in EMEA EM for now given that valuations there are not cheap, positioning is not short, and important country-level risks remain. Add RUB to existing shorts of ZAR and PLN versus OW RON; stay UW the low-yielding Poland and Hungary local bond markets, which are more susceptible to weakness on the back of higher Treasury yields.