While EM is likely to remain in the crossfire of external risk factors, the recent repricing has created some value. However, we advocate a selective approach to risk-taking. We consider sovereign credit to offer the most attractive risk/reward to weather the turbulence, but see pockets of value in local markets as well. The external risk environment has deteriorated: Slower US rate normalisation and a flatter US yield curve should support EM fixed income.
However, China’s FX depreciation has turned an idiosyncratic growth slowdown into a potential external shock. A growth scare should offset the positive of a renewed dis-inflationary trend, exposing local rates and FX. Valuations have improved, mostly in sovereign credit: External debt valuations are balanced compared to US credit and offer enough cushion to weather the Fed liftoff, in our view. On the other hand, valuations in local rates look less attractive, but there are pockets of value. We remain cautious on EMFX.
Technicals favour credit, while flows represent a challenge for the whole EM asset class: Cash balances and primary market activity are more supportive for external bonds than local debt. However, we still see the risk of accelerating outflows. We move to an overweight stance in sovereign credit: We upgrade our stance on Indonesia, Russia and South Africa while moderating our view on Hungary, Romania and Colombia.
Local bonds offer pockets of value: We stay market-weight overall in local markets, but highlight value in Hungary, Mexico and Colombia, all of which offer compelling valuations on an FX-hedged basis due to their steep curves. We remain cautious on EMFX: CEEMEA is set to outperform. Although a temporary stabilisation is possible, we express our caution mostly in Asia.
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