We view EM local yields as attractive at 6.5% (Chart 6) and already compensating for further local currency and duration volatility. We also expect that deflation (due to lower oil prices or weak domestic demand) will create space for further policy easing by most EM central banks, and this could drive local yields lower. Differentiation will be an important performance driver for emerging local market debt in 2015 and we continue to prefer exposure to countries like India and Mexico that have stronger fundamentals, improving external sector balances and positive structural reform momentum. We maintain a negative view on EM curves of commodity exporters like Peru, Colombia and Malaysia. We are positive on Romanian and Hungarian local bonds as we expect monetary policy to remain accommodative and support performance.

 

Further spread compression expected before year-end

With a yield of 5.5% and Spread over Treasuries of 330bps , we consider USD-denominated emerging sovereign debt an attractive fixed-income investment. We expect spreads to tighten to 300 bps by year-end, on the back of solid fundamentals and supportive debt profiles. Technical factors are also positive. Firstly, flows into the asset class should again be positive this year, extending the trend of H2 2014. Secondly, the lack of net new supply (i.e. new issues minus redemptions) will trigger a search for assets with attractive risk/returns.

We like Croatian debt denominated in euro. The government has adopted the National Reform program which focuses on 3 major areas: public debt sustainability, improvement of public sector management, and competitiveness. Croatian debt is also cheap to Balkan peers like Serbia. We are also over-weight in Indonesia and Morocco which we believe are attractively priced investment grade credits with positive reform momentum (e.g. removal of energy subsidies in Indonesia). We closed our underweights in Russia and Ukraine as we acknowledge that geopolitical risks are subsiding, the Russian economy has shown greater resilience in the midst of a sanctions regime than expected and debt restructuring terms in Ukraine might be better than priced by the market. We also added to our positions in Kazakhstan and Venezuela as we believe these credits will be supported by stabilization in oil prices.

 

Forex: still cautious overall

We expect 2015 to be a challenging year for local currencies on further US dollar strength driven by monetary policy divergence between the US and the EU and Japan.

On the “overweight” side we like the CNY, as we consider that the depreciation trend of this PBOC-managed currency has come to an end. CNY is also a low-beta currency and the country is still enjoying a large current-account surplus. We like the Mexican peso as the economy will start benefitting from the reforms implemented over the past 2 years in 2015/17 and US growth recovery will support demand for Mexican assets.

We remain underweight commodity-linked currencies such as NGN and PEN, whose Central Banks could be forced to soften their monetary policy in order to preserve their competitiveness. Yet, our view on these currencies is less pessimistic than earlier.

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