The credit cycle is not tight, but is tightening and the usual suspects are being exposed

The credit cycle is not tight, but is tightening and the usual suspects are being exposed

  • The credit cycle is not tight, but is tightening and the usual suspects are being exposed
  • Emerging markets are seeing the virtuous cycle of the last two years where inflows drive currencies higher and hence flattering dollar returns now turn vicious.
  • Such forced selling does not reflect a credit event, but may cause one, especially in countries and companies with poor balance sheets and weak cash flows
  • Passive funds tracking EM debt benchmarks are particularly exposedto current account deficit countries almost by definition of the benchmark

While ten year US Treasury yields have dipped back below 3%, they  remain in a bear trend and having broken through the previous 2013 highs last week to reach levels not seen since 2011 the market remains weak from a technical perspective. At some point they will become an interesting asset for buy and hold investors who aren’t already forced to own  bonds, but not just yet in my opinion. There will doubtless be some rallies based on short covering (short positions remain significant), but in essence what we are seeing is a steady de-leveraging of carry trade positions as the yield curve flattens.  Interesting  to note that Libor, which is essentially the price of  the key raw material for financial product manufacturers, which  had been climbing relentlessly since late 2015, has now eased back a little which should reduce the urgency to deleverage if not the trend. To be clear, credit conditions are not so tight as to cause problems in the real economy, but they are tightening at the margin and the biggest borrowers on the thinnest margins are the financial markets themselves.

As Mark Twain put it, “History doesn’t repeat, but it does rhyme” and this deleveraging is having some familiar consequences.  As that other great aphorist  Warren Buffet famously said of previous deleveraging episodes , “when the tide goes out you can see who has been swimming naked’ and as the liquidity tide recedes we once again find the modesty of a number of emerging markets exposed,. In particular those countries with current account deficits and thus who rely on foreign funding of their capital account are particularly vulnerable and the first shocks tend to come through the exchange rate against the $. Thus the dollar rally is both cause and consequence of the selloff in emerging markets underway right now. Headlines this week have focussed on the Turkish Lira, but the last few months have seen declines across a wide range of EM currencies, from the Argentine Peso to the Mexican Peso, the Brazilian Real the Russian Rouble and even the Indian Rupee. Indeed, the JP Morgan emerging market currency index, after two years of steady appreciation, has resumed its long term down trend.

Chart 1: Emerging Market currencies resume their long term downtrend

Source Bloomberg, Axa IM May 2018

In many senses this long term trend makes sense in that EM countries  tend to have higher rates of inflation than the US and thus in order to balance the internal and external purchasing power of the currency the exchange rate tends to fall over time (the essence of PPP). This is not to say there aren’t many sub cycles and counter trend rallies or that currencies can’t remain expensive/cheap for considerable periods, but as we have discussed before, the tendency of traders/investors to convince themselves that high interest rates are not associated with inflation and thus will not be offset by a depreciating currency remains intact despite many unfortunate episodes proving it to be otherwise. Often it is capital flows driving the exchange rate above PPP such that high rates of (cash) return attract dollars in  as hot money flows. Obviously this is particularly relevant in current account deficit countries as hot money flows  then give an artificial boost for those nimble enough to pick up both the high yield and a short term currency rally. Eventually though, economic gravity returns and  it looks like we have one of those episodes underway at the moment.

The currency moves then create second round effects as EM bond and equity baskets and funds get repriced in hard currency terms. Thus an overweight position in, say India, which was obviously a popular trade among EM investors last year, benefitted from a near 8% rally in the currency from the late 2016 peak of around 68.8 to the $. This year that has almost entirely been given back (indeed the Indian Rupee is in a very interesting technical position right now). Thus while the Sensex is still positive year to date (total return around 2.5%) in local currency, in dollars it is -4%. Similarly while the Ibo Vespa index is +4.9% ytd in Brazilian Real terms, in US$ terms it is minus 4.7%. Both markets have  broken down  through their  long term moving average (usually a reliable bear signal) in $ terms and may well see further divestment by $ based investors.   By contrast Hong Kong is up 3.2% in US$ terms, Taiwan +2.1%, and MSCI China +4.1%. At the very least this is likely to lead to some rebalancing towards the north Asia markets within EM equity mandates, if it hasn’t done so already which would lead to further flow lead weakness in both the currencies and markets of those countries that are already under pressure.

The Emerging market debt funds are even more exposed to this problem of course, given that the weightings of the benchmarks tend to reflect the amount of debt in the market. This has always struck me as rather odd, you are suggested to have your biggest exposure to the sovereigns with the biggest exposure to a tightening credit cycle. (This is but one of many ‘issues’ I have with passive investing and benchmarks). To take as one example the IShares J P Morgan US dollar Emerging Markets Bond Fund  ETF, ( EMB) , which is the largest ETF in the space ($12bn of assets)  and tracks the J P Morgan EM bond index .As such , it is probably a reasonable proxy for popular holdings in EM debt. Its top geographic allocation is 6% to Mexico, then 5% to Indonesia, 4% to Turkey, 4% to Argentina and so on. Obviously it hasn’t done well this year. Meanwhile,  the Van Eck J P Morgan local currency bond fund ETF, (EMLC)  is smaller, but still has around $5bn, has a higher average volume and has geographic exposure to Brazil, (9.7% )Mexico (9.1%),  South Africa (8.9%),  Poland,( 8.8%) and Indonesia (8.7%). Calendar 2017 the fund was a stellar performer for a bond fund, returning 13.7% in $ terms. This quarter, it is down 8%, taking its year to date performance to -4%. Much of this is reflecting the currency moves discussed earlier. To emphasise,  this is not to criticise the fund, rather to illustrate the challenging environment for all managers given these are reasonable proxies for benchmarks (all data is from Bloomberg ).  History (and Mark Twain) tells us that this will likely trigger capital outflows, which in turn will have secondary effects on the underlying bonds and currencies, forcing other owners to take mark to market hits and so potentially more selling, more flows and so on until the vicious cycle fades.

Against this background we have had the recent focus on the emerging importance of China on various market benchmarks, notably in equities, but obviously bonds are going to be very important too. Perhaps ironically the very fact that the China  A share inclusion in the MSCI Emerging Markets index is so small at the moment as to ‘not matter’ has made international investors question not whether to invest in China going forward, (they will)  but rather whether to bother with the rest of emerging markets at all.  At a series of meetings in Hong Kong and Singapore last week we were discussing exactly this topic. If you want exposure to China, even at the full weight that MSCI envisages giving to China A shares over the next few years, why own it in a basket with India, South Africa and Brazil? China will certainly offer you diversification benefits, but most  of  the rest of the EM basket are basically commodity stocks who are suppliers to China. Over the years I have observed that international equity investors tend to look at the world as comprising US, Europe and Emerging Markets (EM) – they largely gave up on Japan around 20 years ago.  The US based investors (the majority) have tended to switch between Europe and EM for the balance of their non US portfolio, with the latter largely seen as a commodity/cyclical play. Now however, the balance is changing and it looks like China/North Asia is going to at least partially displace EM as an asset allocation offering diversification with greater stability. The current weakness in EM markets is likely to accelerate this trend

To conclude, while notionally about trade wars, higher US rates and a higher US dollar, the current selling in Emerging Markets is much more about market mechanics than an economic or a credit event. The virtuous cycle whereby inflows into EM assets also boost currencies and thus enhance returns to dollar based investors almost inevitably leads to some sort of mean reversion a year or two later and so it is proving right now. It hasn’t yet produced a credit event, but that is not to say that it won’t. Avoiding countries with current account  deficits and companies with weak balance sheets and poor cash flow is always sound advice, but never more so when credit conditions are tightening, Meanwhile, important structural changes in China, both in its economy and its financial markets are presenting a new and credible ‘alternative’ asset class of China/North Asia. Almost twenty years ago as the Euro was created and the concept of Pan European Equity funds took off, UK and US investors had to quickly build up their skill sets to incorporate the new opportunity set. At the recent CLSA China conference my colleague Will Chuang noticed a significant increase in the number of ‘western’ fund managers and analysts taking on the similar challenge of building expertise in China A shares. History is rhyming not repeating, but  it’s going to be a steep learning curve for all concerned! Hopefully a profitable one.



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