Argo Capital Management’s Shamillia Sivathambu (pictured) examines the implications of the formation of a credit bubble in the emerging markets.
The MSCI Global Emerging Markets Index is up more than 60%, eclipsing the 30+% highs of its developed market counterparts while credit spreads have just had their best six month period since the early 1990’s with the J.P. Morgan Emerging Market Bond Index up around 28% so far this year.
But signs of a pullback are already taking shape with spreads in high grade names like Brazil starting to widen, leading some commentators to question the sustainability of such a rally. Having moved so rapidly from a situation where asset prices were trading at levels not seen since the Great Depression to the current situation where spreads have come in dramatically, fears of a new asset bubble is are beginning to get traction with market participants.
In part however, the rally in Emerging Markets (EM) has been justified. Their large foreign exchange reserves, lower debt ratios and better GDP growth compared to developed markets have put them in a stronger fiscal position to stage a rebound from the economic downturn. Growth rates of emerging economies have outpaced the G7 economies every one of the last ten years.
In 2006, the accumulated FX reserves of emerging economies surpassed those of developed economies. They are currently $4.4 trillion, almost double the $2.4trillion of developed economies. Public sector debt as a percentage of GDP is running at close to 110% in the G3 while for emerging economies the average is approximately 40%. Importantly, unemployment in EM has already begun to decline while in the developed economies it is still rising.
In addition, a growing middle-class, favorable demographics and a substantial local savings pool have also helped emerging economies stage a stronger comeback from its lows in the direct aftermath of Lehman’s collapse last September. While emerging economies were not able to ‘decouple’ from the financial crisis they entered into it in much better economic shape than their developed market counterparts.
So EM looks to have passed their stress test and rightly so given that the recent credit crunch did not originate in these markets. However, there is some concern that certain EM assets, namely investment grade credits and equities have risen too much, too soon and overshot their fundamentals.
Returns in the investment grade space might not have that much further to go in terms of spread compression. While we are not there yet as the markets are still not as high as they were before the financial crisis, it is something to be mindful of. Developed world and EM equities have gained more than 60% and 90%, respectively, from their March lows, but still trade 30-35% below their 2007 highs and the FTSE All World Emerging Index is still 25% lower than its record high in October 2007.
No more ‘low hanging fruit’
While EM has out-grown developed markets and continues to do so with the International Monetary Fund putting the differential at approximately 3% a year until 2014, the attractive valuation opportunity that was open to investors just seven months ago has now closed.
The significant widening of credit spreads in investment grade bonds in the aftermath of Lehman’s default has now been substantially reversed. The opportunity to achieve equity-like returns with much less risk is no longer available and there seems little room for further spread contraction in investment grade credits. The next phase of spread tightening is likely to be driven by improving macro conditions rather than funding and liquidity issues.
Furthermore, these cash bonds have greater vulnerability to interest rate risk. While it is never easy to predict with any accuracy how or when interest rates will move, it is difficult to ignore the enormous funding requirements in the US and other major economies. With governments in the US and some European countries running huge deficits, the pressure to raise interest rates to stave off inflation and currency instability is arguably greater.
In such an environment, moving into EM corporate credits and non-investment grade sovereigns may generate higher returns. Second tier credits trading at significant discounts to par have better risk/reward ratios over the longer term.
These are generally credits of companies facing refinancing constraints or have lower credit ratings but still look attractive on a risk-adjusted basis against their investment grade counterparts. Second tier credits could also comprise companies that are in/close to default and therefore have greater opportunities for capital gains.
Their appeal, in part, is derived from the fact they are less crowded trades given they are largely ignored by analysts and therefore not always an investor’s obvious investment choice. However, for the discerning investor, this is where risk adjusted returns are likely to be most abundant over the longer-term.
