EM Outlook - Running on fumes

EM OUTLOOK

Running on fumes

(Hover on each call to learn more)

Emerging market central banks and fiscal authorities have delivered unprecedented amounts of policy stimulus this year, but scope for further policy accommodation may be dwindling. Unlike in previous decades, EM now sorely lacks a compelling impetus for investment, with growth drivers weak and yield compensation low. Increasingly, EM appears to be running on fumes, presenting asymmetric downside risks against limited upside potential. Sovereign credit is our most bullish call to year end, but the credit rally may be running on fumes also. Sovereign spreads should widen alongside corporate spreads in 2021. Duration has performed very well since March, but the tank is empty for the long bond trade (average yields should rise from here). EM currencies are running on empty also, without capital inflows or a resounding macro narrative.

[CEROS OBJECT]5 KEY CALLS (Hover on each call to learn more)

Curve steepeners

Idiosyncratic positions in rates

Leverage to higher inflation expectations

Diversification into TIPS and Gold provides protection against a potential rise in inflation expectations Risks: L-shaped recovery, COVID third wave

7 KEY CALLS

FX relative value in focus

Bullish sovereign credit to year end

Africa continues to offer yield and diversification

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This page contains financial analysis which reflects the opinion of the Cross-Asset Research department of Societe Generale, at the date of its publication. It does not necessarily reflect the views of the other departments of Societe Generale nor the official opinion of the Societe Generale group. This content has been prepared for use by institutional and professional investors and is not intended for retail investors. Investors should consider this report as only a single factor in making their investment decision.

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Curve steepeners

Stable to lower front-end rates coupled with inflation and fiscal risk premia and supply, provides fertile ground for curves to steepen in various EM countries.

THOUGHTS FROM OUR EXPERTS

Alain BOKOBZA, Head of Global Asset Allocation Strategy

Idiosyncratic positions in rates

Curve dynamics will not be consistent across regions and will be heavily influenced by local, external, policy, and technical factors. In some markets position for residual declines in frontend rates or flatter curves.

FX relative value in focus

In a moderately bearish EM currency cycle (or even if EM FX is slightly stronger/flat) dispersion can be highly related to idiosyncratic drivers. Some long dollar exposure is warranted but the majority of our recommendations have a relative value focus.

Bullish sovereign credit to year end

We turned bullish on sovereign credit in April and believe there is room for spreads to tighten by 50bp to year end. When corporate spreads start widening (in 2021), sovereign credit will widen also.

Africa continues to offer yield and diversification

African FIC products offer high yields, low volatility, and diversification qualities relative to traditional EM portfolios. Egypt and Ghana are attractive; Nigeria is at risk due to low oil prices.

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OVERVIEW

EM OUTLOOK

Running on fumes

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Starting to gear to widening credit spreads in 2021

Curve steepeners

OUR 5 Key CALLS

AFRICA – YIELD AND DIVERSIFICATION

Yield and diversification are critical considerations as investors optimize portfolios to factor in a long period of low G3 interest rates. African currencies and fixed income products have proven to be the perfect addition to FIC portfolios over the past few years – offering high interest rates, low volatility, and diversification qualities relative to traditional EM portfolios. However, within the major African markets, selectivity is needed to avoid landmines.

US ELECTIONS – BEWARE THE CHALLENGER

EM FX has tended to weaken in the lead up to, and for several months after, a challenger victory in the contest for the White House (this adverse effect is magnified for high-yielders). Thereafter, high-yielding FX tends to stabilise, while low-yielding FX tends to recover to preelection levels. With an incumbent presidential victory, EM FX tends to strengthen in the run up to the election and appreciate further in the subsequent six months. Where a challenger’s take-over of the White House is accompanied by a sweep of both houses of Congress, EM FX tends to fare worse in the immediate aftermath compared to when there is a divided Congress. A Democratic sweep (our central scenario) could result in weaker EM currencies, lower local bond yields, and wider sovereign credit spreads compared to a Trump victory. We suggest a variety of trades to position for either a Biden or Trump presidential victory.

FX DIVERGENCES

Two notable divergences related to EM currencies have developed over the past few months: (i) EM FX is significantly underperforming G10 and (ii) EM higher yield/beta currencies are much weaker than their lower yield/beta counterparts. EM underperformance versus G10 should remain in place, regardless if the dollar strengthens or weakens against G10. If the EUR corrected lower from excessive positioning it would be worse for EM than the move higher in the EUR has been positive – buyers of EM should beware. Another substantial risk to EM is higher US 10y yields.

MAIN THEMES

US ELECTIONS – BEWARE THE CHALLENGER

The combination of the three themes mentionned in our overview is clearly bullish for risk assets, particularly in the credit and equities space. We prefer to reduce the rate sensitivity of our MAP ahead of the anticipated rise in bond yields in western economies (thus adding a bit more weight on equities) and increase our exposure to inflation expectations. With the economy in recovery mode and infrastructure spending gaining momentum, commodities should continue to do reasonably well, we therefore prefer Commodities to EM fixed income or EM currency exposure. From the current V-shaped recovery, economic momentum should only start to moderate from the second quarter of 2021, after which rising credit spreads should signal the end of the risk rally.

FX DIVERGENCES

We like the growth theme, but we strongly dislike any heavy portfolio concentration on a very few well-advertised US names. As US technology is set to become more volatile, we recommend diversifying into other growth assets available elsewhere. We find attractiveness in Asian equities where cyclical acceleration will be a key feature in 2021. We also find attractiveness in the Australian currency (AUD); Europe, where the Green deal offers multiyear structural growth; and mega trend themes including Asia 5G. On the contrarian side, increasing exposure to cyclical sectors in the corporate space also makes sense after their heavy underperformance (laggards).

AFRICA – YIELD AND DIVERSIFICATION

Published inflation will stay subdued for a while, a consequence of rising unemployment and keeping alive too many zombie companies. However, the most recent policy shifts from both the Fed and the ECB are clearly aimed at raising inflation expectation (more information on this can be found on the Global Economic Outlook) Gold, US inflation-protected bonds and steepeners can deliver well in this context. US real yields should thus remain artificially low, sending the expensive USD further down after a potential pause – but the rising Euro could dampen Euro area inflation expectations.

Main IDEAS