In a survey of cross-asset outlooks for 2014, 13 participants recommended underweight fixed income and only one of the 14 recommended overweight emerging markets. Emerging markets (EM) sovereigns have confounded expectations so far in 2014. Markets appear to have taken the view that liquidity is king, and the weaker you are, the further you have to rally.
The mantra in markets nowadays is that international rates will be low for a longer time, and liquidity is here to stay for a while yet. In recent months, EM asset markets have re-priced a more supportive external backdrop – US recovery with the Federal Reserve on auto-pilot, and a more assertive loosening of policy from the European Central Bank. This has opened the window for more accommodative monetary policies in the EM universe (such as Mexico and Turkey, for example). Moreover, the tapering tantrum led to temporarily more appealing valuations, especially on external debt, which is the focus of this note.
Quantitative easing and other unconventional monetary policy measures have had a huge impact on asset prices in recent years.
The most recent tightening of EM spreads has occurred as the size of the four largest central bank balance sheets reached US$10.5 trillion (i.e., astronomical), an increase of US$6.6 trillion since August 2007, and set to rise further overall.
Few if any of the forecasters predicted just how powerful the impact of global liquidity would be across all asset classes. Markets have largely laid to rest many of their concerns over political and financial vulnerabilities in the so-called Fragile Five.
By March, India and Indonesia were disconnecting from the residual fragile three. By April, post-election Turkey had caught up; by June all the five had re-connected in a sustained rally that – for the time being at least – consigned the “fragile” label to posterity. Spreads in this group of countries tightened from their peaks by a minimum of 73 basis points (Brazil) and a maximum of 129bp (Turkey).
The most spectacular rallies since Feb. 3 have been for the high alpha EMs, where the risks are far more immediately country-specific. All have rallied since Feb. 3: by 133bp for Ukraine (in spite of tanks reportedly breaching its borders), 253bp for Argentina (in spite of the recent US-court ruling in the “pari-passu” case, and 456bp in Venezuela.
Yet the sobering historical evidence for sub-investment grade sovereigns suggests 23 percent of them will default within 10 years, and it is debatable if EM still offer returns that are worth the additional risk.
In our opinion, there may be some – albeit very limited – remaining scope for tightening for investment grade EM sovereigns, but the hunt for alpha has driven down yields too far for risky assets.
What could go wrong?
A faster than expected withdrawal of Fed liquidity could have a direct impact on the demand for EM assets, and an indirect impact because many EM have a heightened sensitivity to market sentiment and global liquidity conditions.
Successive Oxford Economics publications have provided detailed analysis on other risks in the global economic and financial system. Risks include war between Russia and Ukraine, Iraq-led oil price disruption, Eurozone deflation, and a Chinese banking crisis.
Want to predict what will happen to sovereigns in Argentina, Belarus, Egypt, Greece, Ukraine, Pakistan, Turkey and Venezuela? Our tip is to watch the Fed. Shifts in country-specific risk (alpha) will of course continue to play a major part, but these assets are also becoming high-beta, becoming ever-more sensitive to a reversal in market sentiment and global liquidity.
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