BMO Canadian ETF Dashboard

— as of February 28, 2019 —

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Emerging Markets Fixed Income: An EM-phatic Turnaround

Emerging Markets Fixed Income: An EM-phatic Turnaround

Snapshot
A combination of a strong US dollar, a hawkish Federal Reserve and escalating trade tensions weighed heavily on hard-currency emerging market bonds in 2018. However, these headwinds have begun to dissipate, setting the stage for a period of strong returns.

Details
BMO Emerging Markets Bond Hedged to CAD Index ETF (Ticker: ZEF)

Benefits
With macro conditions turning supportive for emerging markets, ZEF’s 5.92% yield-to-maturity, 60.4% investment-grade exposure and relatively short duration of 4.94 years are highly attractive.1

Trade Idea
From a longer-term perspective, emerging market (EM) assets maintain a compelling investment thesis. The proportion of global growth derived from countries outside of the developed world will only continue to increase over the coming decades. EM nations stand to benefit from further structural reform (e.g., strengthening property rights, liberalization of trade and financial market regulations, etc.), infrastructure development, economies of scale from technological adoption and favourable population dynamics. As incomes continue to rise, a burgeoning middle class will bolster domestic demand and reduce economic dependence on exports. These factors should help to structurally improve credit ratings, lower spreads and ultimately help a number EM sovereign issuers graduate to developed market classifications.

While these secular trends remain entrenched, in the shorter term, the path can be a bumpy one. Common sources of volatility include heightened political risk, deteriorating balance of payments and cyclicality stemming from an over-reliance on trade. Nations with less developed capital markets can get whipsawed as foreign “hot money” flows in and out of their borders. In 2018, EMs suffered from tightening global financial conditions and escalating protectionism. Some of the most externally vulnerable countries (namely Turkey and Argentina) were pushed into crisis.

The tide appears to be turning for EM. Although not a certainty, the U.S. and China appear to be working towards a trade deal. With lower oil prices and the U.S. Federal Reserve signaling a more patient, data-dependent approach to future interest rate hikes, EM central banks should enjoy much more policy flexibility. Additionally, the reflationary tailwinds from Chinese monetary and fiscal stimulus introduced in the latter stages of 2018 will begin to show up in the economic data. Based on the chart below, EM fixed income has quietly been outperforming global indices since September 2018. However, investment flows have only very recently turned positive, indicating that there is potential for a much broader rotation into EM assets ahead. 

ZEF is an attractively structured vehicle to capitalize on this positive momentum. The underlying index is GDP-weighted as opposed to issuance-weighted, which helps remove a bias towards more heavily indebted nations. Additionally, the Canadian-dollar hedge reduces exposure to the structurally overvalued US dollar. 

mar-2019-relative-performance-en-848.jpg#asset:2255

Outlook

Allocating to EM debt can help bolster portfolio yield, without taking on excessive credit risk or duration. Although prone to bouts of acute volatility, EM assets play an important diversification role and help align portfolios with long-term structural growth trends. Investor sentiment has recovered measurably of late, as Chinese reflation efforts, more collegial trade negotiations and the prospect of less hawkish U.S. monetary policy have helped alleviate some of the largest concerns. Go long ZEF to position for an improving EM macro environment.       

 

1 BMO Global Asset Management, as of February 27, 2019.

Tyler Mordy
David Kletz

Emerging Markets Fixed Income: An EM-phatic Turnaround

Snapshot
A combination of a strong US dollar, a hawkish Federal Reserve and escalating trade tensions weighed heavily on hard-currency emerging market bonds in 2018. However, these headwinds have begun to dissipate, setting the stage for a period of strong returns.

Details
BMO Emerging Markets Bond Hedged to CAD Index ETF (Ticker: ZEF)

Benefits
With macro conditions turning supportive for emerging markets, ZEF’s 5.92% yield-to-maturity, 60.4% investment-grade exposure and relatively short duration of 4.94 years are highly attractive.1

Trade Idea
From a longer-term perspective, emerging market (EM) assets maintain a compelling investment thesis. The proportion of global growth derived from countries outside of the developed world will only continue to increase over the coming decades. EM nations stand to benefit from further structural reform (e.g., strengthening property rights, liberalization of trade and financial market regulations, etc.), infrastructure development, economies of scale from technological adoption and favourable population dynamics. As incomes continue to rise, a burgeoning middle class will bolster domestic demand and reduce economic dependence on exports. These factors should help to structurally improve credit ratings, lower spreads and ultimately help a number EM sovereign issuers graduate to developed market classifications.

While these secular trends remain entrenched, in the shorter term, the path can be a bumpy one. Common sources of volatility include heightened political risk, deteriorating balance of payments and cyclicality stemming from an over-reliance on trade. Nations with less developed capital markets can get whipsawed as foreign “hot money” flows in and out of their borders. In 2018, EMs suffered from tightening global financial conditions and escalating protectionism. Some of the most externally vulnerable countries (namely Turkey and Argentina) were pushed into crisis.

The tide appears to be turning for EM. Although not a certainty, the U.S. and China appear to be working towards a trade deal. With lower oil prices and the U.S. Federal Reserve signaling a more patient, data-dependent approach to future interest rate hikes, EM central banks should enjoy much more policy flexibility. Additionally, the reflationary tailwinds from Chinese monetary and fiscal stimulus introduced in the latter stages of 2018 will begin to show up in the economic data. Based on the chart below, EM fixed income has quietly been outperforming global indices since September 2018. However, investment flows have only very recently turned positive, indicating that there is potential for a much broader rotation into EM assets ahead. 

ZEF is an attractively structured vehicle to capitalize on this positive momentum. The underlying index is GDP-weighted as opposed to issuance-weighted, which helps remove a bias towards more heavily indebted nations. Additionally, the Canadian-dollar hedge reduces exposure to the structurally overvalued US dollar. 

mar-2019-relative-performance-en-848.jpg#asset:2255

Outlook

Allocating to EM debt can help bolster portfolio yield, without taking on excessive credit risk or duration. Although prone to bouts of acute volatility, EM assets play an important diversification role and help align portfolios with long-term structural growth trends. Investor sentiment has recovered measurably of late, as Chinese reflation efforts, more collegial trade negotiations and the prospect of less hawkish U.S. monetary policy have helped alleviate some of the largest concerns. Go long ZEF to position for an improving EM macro environment.       

 

1 BMO Global Asset Management, as of February 27, 2019.