Stand: 31.10.2022
EMD HC (-0.2%) recovered in October as political risk premiums declined for UK Gilts and global core rates after the appointment of Rushi Sunak as PM in the UK and as US Treasuries rallied on expectations of an end to the Feds hiking cycle over the next six to nine months. EM spreads tightened by 17 bps and nominal and real 10yr US Treasury yields, respectively, rose and fell by 22 bps and 10 bps. The Fed delivered the expected 75 bps hike in early November and retained a hawkish stance in its verbal comments and Q&A, despite introducing new wording in its written statement signalling a slowdown in the pace of hikes going forward. US data remains mixed and the Fed remains fully committed to tightening financial conditions and managing down inflation. We expect that the Fed will move to 50 bps hikes and deliver one or two of these before shifting down to one or two 25 bps hikes, with terminal rates ending at around 4.5% to 5% by mid-2023. The Fed is now fully data-dependent, which is likely to lead to elevated core-rate volatility in the near term. The US labour market and headline/core inflation have shown limited signs of easing. Other economic indicators slowing PMIs, lower advertising revenues of technology firms, softer consumer confidence and higher than 7% long-term mortgage rates already demonstrate some slowdown effects. S&P500 and NASDAQ recovered some of their September slump, at 8% and 4% respectively, on hopes of a Fed policy pivot. Brent Crude (+7.8%) rallied on the OPEC decision to limit production by 2 bpd and softer global growth in the medium term, while European Natural Gas (-50%) declined materially on an untypically warm October, leading to lower consumption and full European gas storage. Industrial metals like Iron Ore (-15.3%) and Copper (-1.5%) continued sliding on mixed signals around Chinese growth, as infrastructure stimulus and easing of liquidity locally have so far been completely offset by further real-estate sector bond defaults and zero-Covid policy constraints. Agricultural commodities such as Wheat (-4.3%) and Corn (+2.1%) posted mixed performances. The trade-weighted US Dollar (-0.5%) gave back some of its prior months gains, in line with the 10 bps fall in 10yr US real yields (1.58% at the end of October), and the EUR (+0.9%) recovered in turn despite the wide US-EU core rate differential and growth momentum favouring the US. EM currencies (-0.7%) underperformed both the trade-weighted US Dollar and the Euro, although EM growth expectations find themselves somewhere between those of the US and the Eurozone, on average. JP Morgan forecast $101.3bn (revised down by $23bn) of gross and -$21bn of net sovereign financing versus - $55bn of asset class outflows for 2022, with YTD net financing running at -$15bn as the Russian invasion, Chinese zeroCovid policies and DM monetary policy tightening have dampened demand for EMD HY YTD. EM sovereigns issued $12bn in October, adding to $83.8bn YTD, or 83% of the full-year forecast, with issuance heavily skewed towards IG versus HY. Asset-class outflows extended into October at -$13bn, split between -$8.5bn HC and -$4.5bn LC, adding to the alreadyrecord YTD outflows of -$86bn, roughly equally split between HC (-$44.4bn) and LC (-$41.6bn). EM spreads tightened by 17 bps to 542 bps, while 10yr US Treasuries rose by 23 bps to 4.05%. IG (-1.2%) under-performed HY (-2.7%), with Ecuador (+11.7%) and Angola (+9.6%) posting the highest and Zambia (-21.9%) and Ghana (-20.9%) the lowest returns. The Fund underperformed the index. The largest detractors of performance were the overweights in Ukraine and Venezuela (both continued to decline in the absence of any conclusive headlines suggesting a reduction in geopolitical risks) and the underweight in Turkey, which outperformed on supportive technicals and limited investor positioning despite tight valuations. The underweights in China, Malaysia and Pakistan, next to the overweights in Angola, Bahamas and Hungary, contributed most to performance. The higher cash position detracted from performance as markets rebounded during the last week of the month on hopes for a Fed pivot that ultimately did not materialise. In October, we added back to distressed credits, as these have traded down below potential recovery values, while bringing the overall HY allocation closer to neutral versus index via reductions in BB- and B-rated credits. We reduced exposure to DomRep and South Africa and added to Angola, Gabon, Iraq, Tunisia, and Brazilian corporates. The Fund s absolute (+72 bps to 6.61yr) and relative (+79 bps to +0.10yr) duration positions increased in October as we neutralised duration versus index in acknowledgement that implied market pricing already reflects the most likely path for terminal US rates. Absolute and relative EMD HC valuations in EM HY are attractive versus asset class fundamentals and versus DM Credit, while EM IG valuations offer less value on these metrics. EMD HC offers a spread over US Treasuries of 542 bps, or 159 bps above its five-year average of 383 bps. The HY versus IG spread over US Treasuries differential is 770 bps, or 311 bps above its five-year average of 459 bps. The medium-term case for EMD is supported by relative valuations in the HY segment, and especially in frontier credits, and a constructive commodities outlook. The Russian invasion of Ukraine and the parallel financial and political isolation of Russia has materially increased risks to the global recovery trajectory and stagflation globally, as well as raised the prospects of extended geo-political uncertainty. We note multiple risks to the EMD outlook from DM and EM monetary tightening, persistent inflationary pressures, soft Chinese growth and starkly elevated geopolitical risks around Russia s war in Ukraine and the simmering US/China conflict in Taiwan. Higher funding costs, a stronger US Dollar and limited access to financing may tempt more vulnerable EM commodity importer countries with limited ability to offset the rise in energy and food prices to pursue debt re-negotiations. In addition, we do not consider that the Chinese state interventionism in the real-estate sector or exit from zeroCovid policies have yet cleared all downside risks to Chinas growth recovery. We remain constructive on energy commodities which should eventually benefit EM energy exporters and EM debt generally. Higher inputs costs and supply constraints are maintaining pressure on agricultural commodities, exposing food importers to social unrest and difficult policy choices. The outlook across commodities categories has improved materially YTD, as Russia and Ukraine are large global energy (Russia only), industrial metals, wheat and corn exporters and reducing or removing commodity exports from those two countries, even on temporary basis, will ramp up supply constraints.