External risks to EM have declined consistently since the beginning of the year as DM political uncertainty has subsided, with European elections producing market-friendly outcomes and US policies so far not focusing on extreme trade protectionism. Geopolitical tensions have stayed elevated, especially in regard to North Korea, but markets appear to be shrugging off the probability of an escalating conflict. The US Fed hiked the policy rate in March and June, in line with expectations, and communicated a gradual unwind of the Fed's balance sheet. Expectations of further tightening this year have been pared back given the continuously subdued inflation environment, which, in turn, has helped anchor US Treasury yields just above 2%. Growth in China remains stable, as the authorities strike a fine balance between deleveraging, reforms and stimulating polices. EM growth remains solid and broad-based, in spite of the only modest rebound in energy prices so far.
We retain an overweight in Hard Currency Debt, being constructive on commodity exporters as EM credits have decorrelated from the tepid oil-price evolution (Angola, Ecuador, Kazakhstan, Zambia) and specific idiosyncratic re-rating stories like Argentina, Ukraine, Egypt and Ghana. We also favour Eastern European credits such as Bulgaria and Montenegro, which are currently benefiting from attractive valuations.
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 EM are still at below-potential growth. We continue to see value in EM Local Rates and remain overweight select high-yielders (Brazil, Colombia, Russia). We also hold an overweight to Mexico (end of the hiking cycle and a 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), Hungary (inflationary pressures will build up in H2 17) and Czech Republic (continued tightening by the CNB).