Emerging Markets Edition!

TODAY: EMERGING MARKETS EDITION!

I just enjoyed reading Ruchir Sharma's The Rise and Fall of Nations, and have thus been thinking more about emerging markets. This will be the theme of today's zig-zagging (some might say disjointed) piece. No overarching thesis or agenda, as per usual; just getting the lay of the land and pointing out a couple of things I find interesting.

Since the term was coined, 'emerging markets' has been a problematic phrase: it refers to so many varied countries that I almost question the premise of this piece. Alas, I will not be doing much to remedy this problem. In the near future, I will be doing some deeper pieces on individual countries, which will hopefully bring some granularity to my EM writing.

First, here is a brief graphical history of the past three decades of EM equities (in log terms, of course):

And here is a chart from Citi's Matt King showing net flows to EM since 2000.

And here is a Bloomberg pull of YTD performance across EM asset classes (spoiler: there's a lot of green):

THE EM-COMMODITY STORY: FALLING R^2

From 2000–2009, the R-squared of MXEF against BCOM was 76%. This means that 76% of the change in the MSCI Emerging Markets Index (MXEF) could be predicted by a linear relationship with the Bloomberg Commodities Index (BCOM). Since the financial crisis, the power of this explanatory variable has declined to 41%. See regressions below. Basically, from 2000 to 2009, commodity prices were rising and emerging markets were rising. An important cause of this was aggressive Chinese investment and consequent demand for raw goods. Since the financial crisis, however, commodities have been extremely weak while EM has managed to hold its own. The logical conclusion (and it is borne out by further examination) is that emerging market economies are less reliant on high-priced commodity exports to maintain economic growth and corporate profitability. Also, it doesn't hurt that accommodative monetary policy has flushed world equity markets with a bid floor.

To really hammer the point home, here's a simple log chart of MXEF and BCOM since 2000:

EM SOVEREIGNS AGAINST DM CREDITS

One interesting pocket of potential relative value is long EM Sovereigns against DM Credits. They move pretty similarly because both have significant risks above UST's and so trade as risky bonds. But the risks associated are different. For corporates, the dominant concern is default while for sovereigns it is a mix of default and currency/inflation risk.

If you're a U.S. PM and you buy HY credits of some U.S. corporation, the risk you are being compensated for (in the form of a few hundred bps in extra yield p.a.) is that the corporation defaults on its obligations. If, on the other hand, you decide that you can pick up those bps via, say, Argentinian bonds, the risk you assume has a very different composition. There is still credit risk, but usually less than with the corporate. The important additional risk you are assuming is currency/inflation risk. What has basically happened recently, is that bond markets are discounting extremely low chances of default (whether corporate or EM Sov), which is why in the below chart you see spreads compressing for over twelve months straight. But the 'complacency compression' has been more intense in corporates than for EM Sovs. This can be interpreted as markets being more concerned about potential EM currency weakness than they are about the fiscal position of corporates or sovereigns.

Here's Morgan Stanley's take on these two different ways of reaching for yield:

If you buy a company's bonds and six months later they realize "oh jeez, we don't have cash to service this," you're going to be looking at a credit event (default/RX/etc). If you buy a tenuous sovereign's bond, it is a bit different. If a government (which controls its fiat currency) has that same "oh jeez" moment, yeah, maybe it'll default. But there's also a high likelihood that some of the decision makers say "ok, just for this one coupon payment, we're going to print some cash." We all know that's a slippery slope, et cetera et cetera. (It goes without saying, this is a drastic oversimplification of the technical process, but it's an accurate conceptual overview of the economics at play).

Also, I will make two semi-obvious statements:

1. For FX to be a source of risk, the security in question must be a locally denominated bond. Sovereign financing varies from country to country, with some preferring to raise most of their funds in 'international currencies' like USD, EUR, JPY, and others preferring purely local currency, or some mix.
2. Treasury management decisions matter. If, for example, a country is 50/50 USD/local_crncy (made-up ticker: 'LCL') denominated, the existence of the USD bonds increase the inflation risk on the LCL bonds, ceterus paribus. Likewise, inflation risk on the LCL bonds boosts credit risk on the USD bonds because resorting to monetization to pay off the LCL bonds means that servicing the USD bonds requires more domestic currency, i.e. a higher tax burden. It's easy to see how these situations can quickly get out of hand.

So, my conclusion, for now, is that being bullish EM rates and being bullish EM FX are one and the same. If you believe the Bloomberg screen above is temporary, the apparently attractive spread differential from Morgan is in fact illusory. But if you have faith in their monetary integrity (at least against DM FX), help yourself to some yield.

Hope this scattershot piece gave you some interesting food for thought. There are some more coherent theses on the way, building off of the themes above.