External risks to EM were still elevated at the beginning of 2018, as concerns around US monetary policy normalization, US tax reforms and NAFTA re-negotiations resurfaced. Whilst we continue to expect orderly and well-communicated monetary policy normalization from the Fed, a sharp increase in US Treasury yields is a risk, given that the market is not fully pricing in the three rate hikes signalled by the Fed. EM-specific risks, notably elections in Brazil and Mexico, the re-negotiation of NAFTA, the political transition in South Africa, deterioration in the Turkey-NATO relationship, more instability in the Middle East and the complex restructuring process in Venezuela may introduce further discomfort in EM areas, although we expect contagion to the rest of the asset class to be limited. The EM growth recovery is now more broad-based and likely to extend due to the rebound in global trade, stronger commodities and stable Chinese demand but has been countered by concerns over the impact of US policy on EM. On balance, our top-down assessment has, therefore, turned more neutral.
However, we retain an overweight in Hard Currency Debt, and are constructive on commodity exporters like Angola, Ecuador, Kazakhstan and Nigeria, and specific idiosyncratic re-rating stories like Argentina, Ukraine, Egypt and Ghana.
Our underweights include US treasury-sensitive credits with tight valuations such as Panama, Peru, Chile, Uruguay, the Philippines and Poland.
The disinflation theme has run its course in most emerging markets, as less negative output gaps and the rebound in energy prices should put upward pressure on prices. However, the high real-rate differential with the US should continue to play in favour of local duration. We are thus neutrally positioned. We continue to see value in EM Local Rates and remain overweight select high-yielders that are supported by high real rates and constructive disinflation dynamics (Brazil, Turkey). We also have an OW position in South Africa on the back of positive election results, expectations of lower inflation and an upgrade in ratings. We are underweight lower-yielding local rates markets in Asia (Thailand and Malaysia) and CEE (Poland, Hungary and Romania).