Search for yield continues

The search for returns in higher-risk assets continued last week, with gains across almost all emerging market (EM) asset classes. Overbought conditions remain in place and the question of a correction is very much open. Looking at G10 government bond yields, real yields are effectively in negative territory, while many emerging markets still offer positive carry. This yield differential remains the key driver of EM outperformance.

From a broader perspective, trading volumes remain subdued, largely due to the summer period. Looking ahead, investors’ attention is likely to shift gradually toward the September “minefield” of central bank meetings. EM assets continue to benefit from the postponement of U.S. rate hikes. Oil was another positive, delivering gains of more than 6% over the week.

FX markets

In the major EUR/USD pair, the exchange rate moved back above 1.11, supported by weaker U.S. data. July retail sales were flat month-on-month, undershooting expectations. Signals remain mixed and the pair continues to trade in a short-term range.

The euro also strengthened on reduced near-term concerns around Brexit, although the outcome remains highly uncertain and the process itself is still difficult to predict.

The Japanese yen, after a brief pause, has again moved closer to the 100 level against the U.S. dollar. This is unlikely to be welcomed by the Bank of Japan, which has been aiming to weaken the yen in order to lift inflation.

China’s central bank is likely to attempt to keep the renminbi below 6.7 USD/CNY for some time; beyond that, further gradual depreciation cannot be ruled out. A year ago, a loosening of the currency fixing triggered market sell-offs and a renewed wave of uncertainty. Policymakers appear to have learned from that episode and a one-off step devaluation now seems less likely.

China’s economy is undergoing a structural transition. Growth is estimated at 6.6% for 2016 and is expected to slow to 6.2% in 2017.

Commodity-linked EM currencies outperformed against the euro, including the Russian rouble and the South African rand. The Brazilian real was the main exception, pressured by the central bank. The South African rand extended its year-to-date gains and moved below 15 EUR/ZAR. From a technical perspective, the pair looks oversold, and the area around 15 may offer near-term support.

The rouble benefited on the one hand from rising Brent crude, which held above USD 40 per barrel. On the other hand, the ongoing conflict with Ukraine remains a geopolitical risk.

The Turkish lira strengthened and moved above 3.30 EUR/TRY. Following the conflict, the currency has stabilized somewhat. The postponement of a potential Moody’s rating downgrade also played a role.

Among the most stable EM currencies were the Indian and Indonesian rupiah. The Indian rupee traded just below 75 EUR/INR. Some concern may stem from higher inflation in July, which reduces the likelihood of further rate cuts in the near term. Price dynamics in Indonesia remain more stable.

Bond markets

Demand for higher-risk credit remains evident, with investors willing to accept tighter spreads for incremental carry. The decline in EM bond yields is a clear reflection of this risk appetite.

Equity markets

EM equities extended their year-to-date highs. Key drivers include low, and in many cases negative, rates in developed markets; the delayed pace of U.S. tightening; the stabilization in oil prices; and improving sentiment toward China.