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Volatility is the price of return

Timely insights on the issues that matter most to investors.

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 how we think fixed-income investors need to adapt to a new regime.

      The winning playbook after the financial crisis was investing for low interest rates and inflation, slow growth, central bank stimulus and low volatility. Yet looking ahead, we see rising rates and inflation, higher volatility and fiscal policy taking over for monetary.

      Zeroing in on the volatility theme, the recent swings in emerging markets (EM) have certainly caught investors' attention. Still, some volatility shouldn't be a huge surprise, especially since 2017 was so notable for its lack of volatility.

      In this post, we'll offer our take on the recent turbulence in emerging markets, and any broader takeaways that investors might learn from it.

      EM trigger?

      Emerging market currencies have taken it on the chin recently. The MSCI Emerging Markets Currency Index is down about 9% the past five months, with much of the damage concentrated in weaker economies.

      Now, investors will be watching to see if the pain spreads into other areas, such as developed markets and equities -- especially since September and October are known as volatile months.

      Yet, investors should remember that volatility often creates opportunity for long-term investors who can handle the swings. And, we think we are at least close to that point in emerging market bonds.

      One reason is that it seems some EM local currency bond managers sold positions after recently overweighting them amid a broader hunt for yield.1 We would note that it is pressure on the most liquid issuers that is a sign of a bottoming process. How long it will take is an altogether different question, but this is something we are watching.

      Overall, most investors and financial advisors haven't rushed for the exits in funds that invest in emerging markets, according to some reports.2 This lack of panic so far suggests that investors may only have small, strategic allocations to EM bonds in their portfolios. Therefore, they may be able to better stomach the well-known volatility in the asset class, and are aware that the economic growth of EM is a long-term theme despite recent weakness in specific countries.

      This jibes somewhat with our own "new playbook" thesis that in this difficult fixed-income environment, volatility is the price of return.

      Not the end of the world

      Looking at emerging market bonds now, we see an asset class that has quickly gone from loved to almost totally hated, due to currency volatility. And that may present an opportunity to establish long-term positions. In fact, based on implied volatility in emerging and developed (G-7 countries) currencies, we haven't seen buying opportunities like this since around 2002 and 2009.

      J.P. Morgan calculates volatility indices for currencies, similar to how the CBOE Volatility Index (VIX) is designed to measure volatility in U.S. equities. The spread between the "VIX" of emerging market currencies and G-7 currencies is the largest in years. In other words, investors expect much more volatility in emerging currencies, relative to developed, as the figure below shows.

      Blog Image EM Spreads Sept 6

      In general, we believe the currency markets are too pessimistic on emerging economies. Also, many investors who traditionally stick to investment-grade bonds have moved into emerging markets as they search for yield in a low-rate environment. When they become forced sellers, that is when opportunities may arise. We are beginning to see this in local markets -- many of the underperformers tend to be the most liquid. Without capital inflows, price is the adjustment mechanism, and price will ultimately be what clears the market.

      Expect more volatility

      Of course, buying EM bonds now when they're seemingly universally hated is not easy. The immediate risks include an escalating trade war, U.S. government shutdown, Brexit and political tensions in Italy and elsewhere.

      So, while there are political risks that could take time to sort out, we just think investors have grown too bearish on EM bonds and currencies.

      Putting it all together, the return of volatility is a reminder that what has worked well in recent years may not work as well going forward. For example, simply taking duration risk and focusing on investment-grade bonds has been a decent strategy in recent years, without much downside.

      However, we think investors will have to explore "riskier" asset classes like emerging markets in coming years to maintain performance. And volatility, while painful, often creates the best opportunities.

      Bottom line: Rising volatility may mean better opportunities for active fixed-income managers who can capitalize. EM, like any market, will see fits and starts, and rich and inexpensive issuers. This is why we think investors should embrace the new playbook, and leverage flexibility in finding individual opportunities within and across sectors, and not merely focus on single exposures or asset classes.