Market Views: Fixed Income
EMD Relative weekly notes
Week Ending January 8, 2016
Dollar emerging market debt started the New Year down only slightly.
You would not expect to read that sentence in the context of, as of this writing, a US equity fall of over 5% as well as 6%+ losses in European equities and a 7% drop for the Nikkei to start the year. A rally in treasuries helped fixed income in general, of course, but US high yield returns were similar. This gave investors some hope that asset classes that were already cheap might represent reasonable investment propositions even in a stormy environment. The most proximate cause was the Chinese turmoil over botched equity interventions and a falling currency—a near carbon copy of the late August 2015 scenario when global asset prices reacted in a similar manner. That episode was followed by a recovery in prices until the December fall, which was probably aided by the Fed rate hike.
This time, we think the China jitters may be more extended. If, as a meaningful instrument of economic expansion, the Chinese have chosen a faster currency depreciation over boosting credit and other policies, then the falling currency will continue to be an issue for risk appetite. Though the near-term move appears steep on a chart (see below), the total depreciation since mid-August is just over 3%. Most observers reasonably believe that only a depreciation of over 10% would begin to be felt in the ailing manufacturing sector. For context, keep in mind that other emerging market currencies are now down by about 50% since mid-2013. December’s reserve drop in China of $108 billion was historically very large, but total reserves remain comfortably over $3 trillion.
Source: Bloomberg; as at 08 January 2016
Perhaps one of the biggest issues for markets is a near-total lack of clarity on what Chinese officials are thinking: what is their view of a fair level for the currency, how much capital flight are they willing to endure, how does the currency fit into a coherent medium-term growth strategy—just for starters? Perhaps some answers are shortly forthcoming given the turmoil already experienced, but the example of China’s intervention into equity markets, with poorly constructed circuit breakers on and off, does not give confidence that the any potential answers will assuage tense investors.
The shock absorber in emerging markets will be, as it has been, currencies. We noticed more commentary as the year began acknowledging how cheap EM currencies have become, but we doubt they can rally without adequate resolution of the China issue, if not also a stabilization of commodity prices. Valuing currencies is a fool’s game, but we do believe that the fall in those currencies, now being exacerbated by the absence of risk appetite, eventually only means the potential gains could be that much fatter once negative drivers dissipate. In our opinion, the day very well may come when they will be viewed as one of only a handful of opportunities offering solid above-average returns in a low growth world (with that recognition coming only in hindsight, of course!)
For now, though, we have found that the full opportunity set of emerging market assets currently offers dollar debt with investment grade spreads near historical highs of 300 basis points. A discussion with our high yield trader colleague late this week suggested that yields for EM investment grade opportunities are, in many cases, equivalent to CCC-rated US high yield, as an example of broad relative value. We see value emerging especially in Latin America, the worst-performing region last year, which represented in some sense the “eye of the storm” as commodity prices collapsed. This year, that region may actually be out of the spotlight, broadly speaking, as Asia grapples with the CNY fallout and European EM seems pretty fully valued.