External risks to EM have declined consistently since the beginning of the year as DM political uncertainty subsided with European elections producing market-friendly outcomes and US policies so far not focussing on extreme trade protectionism. The US Fed hiked its policy rate in March and June, in line with expectations, and communicated a gradual unwind of the Fed balance sheet. Despite inter-month volatility reflecting the return to a more hawkish Fed stance, 10-year US Treasuries appear anchored for now by subdued growth and inflation in the US. As in H1 2017, EM growth is no longer surprising relative to expectations, but remains solid and continues to support the thesis of a synchronized global growth recovery – which remains a positive driver for EM fundamentals.
We retain an overweight in hard currency debt as we are bullish on cheap commodity exporters (Angola, Azerbaijan, Ecuador) and specific idiosyncratic re-rating stories such as Argentina, Ukraine, Egypt and Ghana. We also favour Eastern European credit, which is benefiting from attractive valuations (such as Bulgaria and Montenegro).
Our underweights include US treasury-sensitive credits with tight valuations such as Panama, Peru, Chile, Uruguay, the Philippines and Poland. We are also underweight South Africa, which is suffering from tight valuations, domestic political transition risks, downgrade risks, insufficient fiscal adjustment and weak growth.
Local rates will continue to benefit from EM disinflation and accommodative EM central bank policies, although the easing cycles might be shallower than expected given Fed monetary policy normalization. The EM cyclical growth recovery is also expected to continue, as most EMs are still at below-potential growth levels. We continue to see value in EM Local Rates and remain overweight selected high-yielders (Brazil, Colombia, Indonesia, Russia). We also hold an overweight in mid-beta countries like South Africa (soft growth and disinflation) and Mexico (end of the hiking cycle and political risk premium that could be corrected in the near term on limited adverse US policies).
On the other hand, we are underweight lower-yielding local rates markets in Asia and CEE such as Malaysia (limited value) and Hungary (inflationary pressures will build up in H2 17).