Friday, May 15th, 2020

No Read Across in EM

Like many other commentators, we are becoming more concerned about the situation in EM Sovereign Bonds, but our reasoning is significantly different. The conventional bear case is straightforward: the pandemic recession will wipe out at least one year’s worth of growth; the slowdown in the US will crimp their export earnings and this will be worse if the country is reliant on oil exports; the strength of the dollar will make those debts more expensive to service as their own currencies depreciate. We don’t disagree with any of this, but while this is a good top-level analysis of what is happening in Latin America and the frontier markets of Africa, it is less applicable to the rest of EMEA and most of Asia.

It would be foolish to dismiss the risk of default, but for many frontier markets China is the largest single external creditor, ahead of official agencies and US private sector bank / bond funds. Imposing harsh penalties for dollar-denominated defaults will only drive these countries further towards China, which is not what the US State Department wants. The borrowers may not want to go there, but they know it is a useful negotiating card. All in all, we still think that a well-diversified portfolio, such as the main ETF, will provide a better total return over the next 2-3 years, than a US domestic portfolio of equivalent credit quality.

However, in the short-term there is one critical difference: The Federal Reserve is not going to buy the dollar-denominated obligations of a foreign government. As of this week, it has begun buying Investment Grade bonds issued by US domestic borrowers and there is already speculation that, if the situation gets really bad, it may even extend to High Yield. But in our view, buying EM bonds will always be a step too far. The medium-term total return may be superior, but the short-term downside is definitely worse. For this reason, we expect our model to downgrade EM Bonds to underweight in the near future.

So, does this mean we should also move to an underweight in EM Equities? We don’t think so. The main reason is that the big weights in the EM equity index come from Asia, not Latin America, especially now that China is partially included. Many of these countries run current account surpluses, which may even grow because they are net-oil importers. They also dealt with the pandemic earlier and more effectively than the US or Europe, so the hit to their domestic economies has been smaller. There is a chance that GDP in these countries may be back to its previous peak by the end of 2021, whereas for Europe and the US, this date is probably 2022 at the earliest.

The formal logic of our process highlights an important point. The realised volatility of the EM Equity index is now materially lower than any other region – not just in local currency, not just relative to its own history – but in absolute US dollar terms. Investors appear to believe that investing in EM Equities is less risky than the US at the moment. Of course, the market may be wrong, but the evidence suggests that Asian governments and banks have been more effective at containing the virus and its economic side-effects. The read-across from bonds to equities may work in Latin America and frontier markets, but investors should be careful before they treat Taiwan or China like Brazil or Mexico.

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