See beyond the short-term headwinds

We believe that with yields around 6.5%, external emerging market debts remain an attractive investment in a global fixed income context and relative to EMD LC. We acknowledge however that many factors have recently depressed the appetite for EM hard currency debt. The launch of US monetary policy normalization, the risk of hard landing in China and the commodities down trend have pushed spreads wider.

Yet, on technical considerations, EM hard currency debt remains an attractive investment offering spread versus Treasuries north of 400 bps (Chart 7). Net new supply (gross issuance minus coupons and redemptions) is expected to remain negative in 2016 as well, and, is, therefore supportive. Over a one year horizon, we expect positive asset class returns of around 4%, on an assumption of 10Y US Treasury widening to 2.75% and a 25bps EM spread tightening (Chart 7).

We like Central European credits like Croatia, Hungary, Romania as these are all commodity importers. We however reduced our positions on Belarus, Armenia and Georgia on tight valuations. In December, we increased our exposure to Venezuela on the better-than-expected performance of the opposition in parliamentary elections and a rising probability of a non-violent political transition. We also like Mozambique due to attractive valuation, lower liquidity and an IMF bailout. On the bottom-up side, we switched out of Brazil sovereign debt to add to exposure in the Province of Minas Gerais, on attractive relative value.

Challenging market environment for local rates but longer term prospects remain appealing

Emerging market growth underwent numerous downward revisions in 2014 and 2015. At the same time, persistent currency depreciation is likely to pressure inflation higher in most emerging economies. As a result, a number of EM central banks do not have space to ease monetary policy further which is not a positive element for local EM debts.

From a valuation perspective however, the asset class remains one of the most attractive in the Fixed Income universe, with a yield above 7%. The valuation of the asset class is, therefore, appealing and the yield provides a comfortable cushion against further currency correction.

We remain cautious on many Asian local rates markets. We are underweight Thailand and Malaysia on higher sensitivity to Chinese slowdown, tight valuations and elevated political uncertainty.

We also remain positive on Russian and Indonesian local rates. Indonesia is expected to benefit from declining inflation, attractive carry, improving macro environment and renewed structural reform commitment. In Russia, we expect disinflation to trigger further rate cuts and decline in yields from currently elevated levels.