EM in crisis, US on standby

Bonds

Althea Spinozzi

Fixed Income Specialist, Saxo Bank

For many, this is the first week back at work after a relaxing summer holiday. As such, I feel it is our duty to be clear on what is happening in the market: this is the beginning of the long-awaited crunch caused by the same money that so aided the old and new world during the 2008-7 crisis. 

The only difference this time is that the narrative contains no real ‘bad guys’ (read: Lehman et al.). Instead, we have a bunch of ‘good guys’ whose good intentions have allowed a potentially explosive situation to develop.

Help without a clear recovery path

Since the financial crisis and the 2013 European peripheral debt crisis, the Federal Reserve and European Central bank have put an enormous amount of money into the system to avoid a domino effect of defaults that would ultimately see SMEs and weaker corporates cut off from financial markets. 

This strategy worked well in one sense because the economy was able to recover; defaults decreased to historic lows and just when inflation started to pick up, central banks began to hike interest rates and discuss ending quantitative easing. Stopping QE, however, means that central banks need to disinvest the same money that has thus far supported equity and credit valuations. The hope is that the market won’t notice; the reality is that we cannot simply ‘rewind’ to pre-crisis circumstances and withdrawing this money will leave a huge hole in the market, making it more vulnerable to volatility.

We are just at the beginning of this balance sheet disinvestment plan (see figure one) and we are already seeing signs of distress arising from emerging markets. If this is the beginning of a crisis, will the Fed have enough ammo to manage a crunch?

Fed balance sheet as a percentage of GDP (source: Bloomberg)
The first signals of the debt binge’s side effects 

Easy money pushed investors to take on more risks, and pushed corporates and governments to issue more debt. Now that interest rates are going up, companies are facing refinancing risk after years of this being among the least of their problems. It is evident that overleveraging has become the real disease at home and abroad, and it has created create a bubble in both equity and credit markets.

Emerging markets were the first victim. It has become clear that EMs are on the brink of collapse and if investors had any doubts, Argentinian president Mauricio Macri has posted a video on YouTube (why not a more formal method of communication?) where he admits to the world that the country is in an emergency situation. The Argentinian peso has collapsed 50% against US, year-to-date. With the central bank raising rates to 60% and the government reintroducing export taxes on crops, we can expect things to go from bad to worse as politicians and the population start to resent the situation. 

Macri enjoys strong support from an agricultural lobby that will doubtlessly be displeased by the emergency measures implemented, raising the likelihood of political unrest. A similar picture can be drawn for the Turkish situation, but in Turkey there is one big difference though: Erdogan is fighting the Turkish currency crisis by partnering up with Russia and Iran – big regional players, but hardly the West’s best friends. This week, Erdogan, Putin, and Rouhani will meet in Tehran to discuss the Syrian situation, but we can rest assured that a few words will be spent on sanctions and how these countries can cooperate to counteract US efforts to “punish” them.

Things are no better at home

Investors cannot even feel safe at home. The US yield curve is the flattest it has been in 11 years and this hints to a possible inversion as Fed chair Jerome Powell promises to hike rates twice more this year and four times next year. On top of all this, we have President Trump fueling a trade war whose ultimate impact on world markets remains unknown.

When we look at the US credit space we see that the junk bond supply has been drastically decreasing this year. Not only did this August was the slowest increase since 2015, but year to date there have been 27% fewer issuances compared to the same period last year. This is of course heavily due to the fact that interest rates are on the rise, but it may also be that investors’ appetite is changing. High yield corporate bond spreads have been widening less than EM and investment grade corporates year-to-date. This not only implies that investors find better value in the investment grade space, but that high yield names may be doomed to a repricing as the Fed continues along its tightening path.
CDX index for EM (orange), IG (blue, and HY (green, source: Bloomberg)
I believe that at this point, investors should really ask themselves what they want. Would they like to invest in the short part of the curve to be less exposed to late-cycle volatility (and thus remain able to invest in better opportunities later on)? Or do they believe that we will never get out of QE and that the long part of the curve is destined for further tightening given trade war/political uncertainty? 

Maturity is only one of the concerns that investors face. The biggest one at this moment is risk selection, and looking at how are things are panning out, it would be wise to remain cautious on EM and HY while watching the good opportunities arising in the US investment grade space.
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