Emerging market debt yields and their strong correlation with recent commodities trends have prompted CLSA’s Christopher Wood to remind us, in his Greed & Fear client newsletter, of the moment in the 1970s when Japanese government bond yields broke through US Treasury bond yields for the first time in the post-war period.
At the time, it was seen as a big deal, although now, it is taken for granted, he notes. But this historic episode raises the issue today of the potential for emerging market debt yields to trade eventually through US Treasury bond yields, says Wood.
The possibility of such an outcome can no longer be dismissed out of hand, he adds, “given the ability of emerging market debt spreads to continue to decouple from rising credit spreads in the US”.
The relative immunity of EM debt spreads is particularly striking considering how, over the past decade, waves of global risk aversion have immediately hit emerging markets, Wood notes. The recent trend, however, is “eminently rational”, he argues: “Sovereign fundamentals have improved dramatically in emerging markets, both in terms of the decline in debt outstanding and the related boom in resource-related revenues. Russia is the most extreme example of this phenomenon but far from the only one”, he says.
The bottom line, according to Wood, is that the continuing impressive resilience of the EM “commodity complex” so far in 2007 is, to an extent, insulating emerging market debt yields from the US subprime fallout far in 2007.
Of course, warns Wood, “there remains a tactical risk to the commodity complex if a renewed housing-related US growth scare hits later this year, and if investors start to worry again about the US consumer.”
His guess is that emerging market debt spreads “will suffer a bit of a wobble if commodities are hit, most particularly the oil price”. But if commodities remain strong, “the surprise will be that debt spreads in the emerging area will keep declining whatever happens to CDOs, CLOs and the like”.
Indeed, if structured finance “completely blows up”, Wood says, “this could even lead to increasing demand for emerging debt given the shrinking supply of such paper”. That is how emerging debt yields could eventually trade through US Treasuries, in Wood’s view.
His conclusion, therefore, is that “it does not make much sense to hedge structured finance risk by shorting emerging credit spreads, unless a contrarian bearish view is taken towards commodities”.
Meanwhile, in the bigger picture, any clear decoupling of emerging market debt from US-related consumer and corporate debt is highly bullish for Asia and the rest of the emerging market equity universe, he notes.
So, “it is this sort of environment that will justify Asia ex-Japan trading at twice the forward P/E ratio of the US equity market”, which is where Wood expects the current Asian secular bull market ultimately to climax.
