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EM volatility highlights need for different thinking

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Kathleen C. Gaffney, CFA, Director of Diversified Fixed Income, Eaton Vance Management and Henry Peabody, CFA, Diversified Fixed Income Portfolio Manager, Eaton Vance Management

      Boston - In recent blog posts, we've discussed why the recent ruckus in emerging market (EM) bonds and currencies was something we were looking for in what we're calling our "new playbook."

      To refresh, the new playbook refers to strategies that we believe can prosper in the environment we expect of higher inflation and interest rates, dollar weakness and increased volatility. Another key concept is navigating the transition from monetary stimulus (central banks) to fiscal stimulus (governments), and its potential impact on markets.

      For us, the new playbook means embracing maximum flexibility to take advantage of the opportunities presented by the large-scale transitions taking place in the economy. In this post, we'll try and make the case that the recent volatility may be an opportunity for long-term EM investors.

      Going beyond EM bond benchmarks

      Despite recent volatility and "contagion" talk, we still think EM deserves a place in diversified bond portfolios -- but with an important caveat.

      Essentially, we believe investors who rely on benchmarks for exposure to EM debt may end up disappointed in coming years. Also, we think viewing EM bonds simply as an asset class or sector that can add value to traditional, developed-market indices may be a mistake.

      Instead, we favor a flexible approach that focuses on trying to identify the individual EM countries offering the best value -- for example, countries facing near-term challenges that may be distracting investors from their long-term potential. In other words, relying solely on traditional benchmarks may be too restrictive to implement our new playbook.

      Remember, in many broad bond indices, an individual country's weight is determined by its total debt outstanding. Therefore, the most indebted countries have the biggest index allocations. Instead, we think it makes more sense to focus on countries with potential for improvement and reform, and also those that may be offering compelling value after falling out of favor with investors.

      Barbell approach: Go where the growth is

      Although EM bonds have historically been more volatile than developed markets, we think long-term investors may be ultimately rewarded for the rougher ride.

      Also, if U.S. rates keep rising at the pace we've seen this week, it would likely spell trouble for rate-sensitive, investment-grade sectors that are large holdings in many bond portfolios -- Treasurys and investment-grade corporate debt, for example. In fact, we think those two areas are expensive now, and it's one reason why we're turning to EM in search of value.

      Shortening duration to reduce rate risk is a common response to rising rates, but we believe that approach is part of the "old" playbook. Instead, we favor a "barbell" approach -- cash positioning at one end for the liquidity to capitalize on opportunities as they arise, while the opposite end comprises what we see as long-term value in emerging markets.

      EM debt provides a source of long-term value, in our view, as countries such as Brazil, Mexico and India offer higher yields and growth potential than we find in developed markets. We believe the recent shakeout in EM bonds may have been exacerbated by yield-chasing investors running at the first sign of trouble due to tariff and trade fears.

      Stepping back to look at the overall fundamentals of EM, we see the rise of the middle class is not unlike what was going on in the 1950s and 1960s in the U.S. after World War II. Now we have emerging markets with large populations closely tied because of the internet, very aware of developments in the rest of the world, and economies that are going more mainstream.

      Yet, to repeat, we think finding the most attractive opportunities within EM involves being flexible and a bottom-up, value-oriented approach.

      Where we see EM opportunity

      So what do we like now?

      Latin America is particularly impressive because the region has grown its capital markets in a way that is reminiscent of the developed world when the U.S. high-yield market was first introduced. The access to capital and the depth and liquidity of such markets demonstrate how fixed income is becoming more important to growth in the region.

      Latin America is dealing with long-standing corruption that has held it back. We see these as early opportunities to take on country risk, currency risk, and credit risk too. Within the region, we like Mexico and Brazil. In both of those countries, the sovereign bonds offer an attractive yield pickup -- income that you can't get in the developed world. And we see the politics as stable in Brazil with long-term potential to improve. The political climate is also improving in Mexico as a result of the recent election. There was a lot of fear about populism hitting both countries, but we see the tide turning more toward reduced corruption, stability and improving the lives of the middle class.

      Mexico's currency had been hit mainly because of the U.S. election and concerns about the border wall. Following this, the election of Andrés Manuel López Obrador (AMLO) caused another exodus in the currency. As it currently stands, it is inexpensive on a very long-term and inflation-adjusted basis. As a result, the peso offers deep value versus the U.S. dollar, in our opinion. While Brazil has rebounded nicely in the last couple of weeks as a result of a stabilizing environment there, the country may go sideways until we see some evidence of pension reform. We think the yield and the fundamental direction support the prospects of both Mexico and Brazil.

      These views don't mean we are turning away from Asia. We are looking at candidates for reform potential and would highlight the long-term potential of India, in terms of a rising middle class, rule of law, and a strong education system. Obviously, there is some uncertainty with this view, but we like the general direction.

      Bottom line: As we have highlighted in our recent blog posts, the role and behavior of fixed income in portfolios could be in transition. Investors have the opportunity to think differently and seek returns that may be based on behavioral biases, and that will not be available in the perceived safety of traditional and benchmark-oriented strategies.