EM Credit in 2017: Rotation, Interrupted – Deutsche Bank

Research Team at Deutsche Bank, sees the credit rotation into EM as merely interrupted and expect inflows to return eventually thanks to three factors.

Key Quotes

“First, we expect EM credit fundamentals to continue to improve, providing a much needed pull-factor. We expect the multi-year trend of negative credit rating migration in EM credit to stop, if not reverse, in 2017. Second, EM credit market valuation, while tighter than at the start of 2016, is much more attractive than at the onset of the earlier taper tantrum and commodity shocks. Finally, EMD funds are yet to recover fully the allocations they have lost since 2013, and global bonds are under-allocated to EM assets, indicating lighter positioning than at the onset of the earlier significant selloffs.” 

“We expect the year in EM credit to play out in Two Acts. We expect a challenging start to the year for as uncertainty over US policy priorities will begin to be resolved, likely adding to core rate volatility. At the same time European political worries will likely be ratcheting up. During this period there is a high risk that benchmark credit hit wides of 400bp (vs. 365 current). Our base case is that peak uncertainty of Act I is resolved into moderate outcomes in Act II, with US growth rising, but inflation and rates contained, and moves towards greater protectionism limited. This should allow rotation into EM debt to resume, leaving benchmark spreads overall tighter by year-end at 325bp, leading to total returns at 7.3% for the year (assuming 2.5% UST 10s).” 

“We expect sovereign differentiation to remain a key driver for performance. We enter the year overweight Argentina, Brazil, Mongolia, Peru, Russia, South Africa; whilst we are underweight Colombia, Mexico, Hungary, Poland and  Sri Lanka. The 10Y point continues to be the sweet-spot on curves for now, although we expect to add more duration later in the year as rates settle.”

“We believe the rotation into EM will eventually return thanks to the stronger fundamentals, improved valuation and continued demand for yield. Over the near term, however, risk for continued retail outflows is high as rate re-pricing and policy uncertainty continue. Post election outflows from EM hard currency funds have been largely contributed by ETFs (34% of total outflows), which had seen record pace of accumulations earlier this year (current AUM: USD22bn).  We forecast USD28bn net issuances by EM sovereign issuers in 2017 (gross: USD120bn, repayments USD92bn), significantly lower than 2016 levels (USD55bn). Repayments are front-loaded in the first four months. Post US election, investor positioning has likely reduced to neutral.”