Emerging markets are in focus for both the Lex and Short View columns, as they muse on the resilience of EM markets – in equities and debt, and particularly, in local currency EM bonds, which are showing what Lex calls a “reversal of normal patterns in a sell-off”.
Yet, while bonds generally have escaped the worst of the turmoil in credit markets, Lex asks: “Should developing economy junk really perform better than junk from the developed world?”. For now, at least, the broad answer is, Yes.
The spread of emerging market (EM) corporate bonds over US Treasuries has risen by considerably less than the comparable spread of US corporate high-yield bonds, the column notes. “Between July 18 and August 6, spreads on Lehman Brothers’ US corporate high-yield index increased by 101 basis points to 418bp. Spreads on Lehman’s index of hard currency EM corporate debt increased by just 56bp to 251bp, while hard currency EM sovereign spreads rose just 43bp to 206bp. Emerging market bonds denominated in local currency have fared even better,” Lex adds.
Perhaps, ventures Lex, “transient technical factors” played a part in this apparent anomaly: “The derivatives market initially reacted more negatively: at one point the EM CDX tradeable contract had increased by 93bp points to about 205bp. The index is made up of credit default swaps – a kind of insurance against default – for various emerging market sovereign credits. It is often used to hedge illiquid bond positions and, as one of the most actively traded instruments in the sector, may be a better guide to investors’ immediate response than the cash market.”
Technical factors may also help explain the outperformance of local currency debt, adds Lex. “Crossover investors – who buy high-yield and emerging market credit – may be more likely to own hard currency debt. They could have liquidated emerging market positions to cover losses in high yield.”
But there are other explanations:
“Emerging economies are, in general, less dependent on US growth than in the past and have better balance sheets. Investors may legitimately prefer high-quality emerging market companies, such as Brazil’s CVRD, to lower-rated, very leveraged corporates in countries such as the US. Such new realities suggest that at least part of the historically unusual anomalies between emerging market bonds and developed market high yield may well last.”
Meanwhile, John Authers in an early Short View column ahead of the Fed’s interest rate decision on Tuesday, notes that among the very few clear trends emerging from the recent and extreme markets volatility has been a strong and untarnished faith in emerging markets.
“Normally, in risk aversion, emerging markets would be expected to fall further than the market as a whole. They have budged but barely any more than the rest of the market,” Authers says.
By Monday’s markets close, MSCI’s EM index had fallen 7.5 per cent since July 19, when the MSCI world index peaked, notes Authers. The world index itself was down 6.1 per cent. For the year, emerging markets were up 16.5 per cent, against 4.8 per cent for the world index, he adds.
So, compared with other risky assets, “faith in emerging markets remains robust”, says Authers, though he can’t resist adding: “But faith in human frailty also remains constant”. Consider, he says, that shares in Las Vegas Sands and Wynn Resorts “have both gained more than 40 per cent in less than a month”.
Overall, though, the evident robustness of EM markets appears to be part of what CLSA’s Christopher Wood (referring specifically to Asia in a recent issue of his client newsletter Greed & Fear) called the “secular asset reflation story”. Wood notes the growing ability of EM debt spreads to “continue to decouple from rising credit spreads in the US” and, in his latest newsletter, examines how Asian and other emerging asset markets would be key beneficiaries of a massive deleveraging cycle now underway.