M&G shorts EMD in anticipation of dollar spike

Investors are not being compensated for the credit and illiquidity risk they are taking when investing in local currency emerging market debt, according to M&G’s global bond team.

Manager Mike Riddell (pictured) sits on the management team for the M&G Global Macro Bond fund alongside Jim Leaviss. He said the team is currently shorting local currency emerging market debt, where they view credit spreads as far too tight and argue that investors are not being compensated for potential illiquidity – particularly in the event of a market shock.

The team is holding credit default swaps against Brazilian, Russian, Turkish, Indonesian and South African debt.

Dollar appreciation

The team’s call on emerging market debt is also underpinned by a view the sector will be vulnerable if the dollar appreciates. This is their central scenario and is linked to a bullish view of  the US economy.

As the Republicans and Democrats seek to flesh out a deal ahead of the fiscal cliff at the beginning of next year, Riddell anticipates a solution will be reached and expects GDP could be roughly around 1% lower as a result, not as great as the 4% drop that has been estimated.

‘The market is obsessed with the fiscal cliff, but we think a much bigger driver longer term is the very strong outlook for the US housing market,’ he said. ‘We think the US housing market could easily grow between 5% and 10% a year for the next two years. So the US economy looks very strong.

‘At the same time you have got the Federal Reserve starting to move away from saying we won’t hike rates until mid-2015. They are now saying “when unemployment reaches x%” or “inflation is y%” or “nominal growth is...”. They have not said what the variables are, but they are focusing on a moving target rather than a fixed time.

‘What does this mean for our fund? If the US is increasing interest rates, that will be very good for the US dollar and emerging market currencies normally do the opposite to the US dollar. It is also bad for Treasuries,’ he said.

It is for this reason the team also has a short position on US Treasuries. ‘Emerging market debt valuations look terrible. We think the US economy looks strong though and the Federal Reserve will be increasing interest rates sooner and more than the market expects,’ he added.