Developed economies are still accumulating debt, making it tougher to tighten monetary policy and to grow. Recently, the market has been pricing in a policy mistake by the Fed – evident in lower breakeven inflation, rising real yields, bigger risks for credit markets, weaker stock markets and a stronger Dollar. We think the true preferences of central banks in developed economies for supporting the recovery are easily revealed by market weakness.
In our view this makes current valuations in EM attractive now, especially in local markets. The recovery from the Taper Tantrum last year has only been interrupted, not derailed.
The recent loss of confidence in the US growth outlook has triggered the usual knee-jerk selling of EM assets even though this is not an EM event. EM currencies are down 6.7% against the Dollar since May, but spare a thought for the Europeans and the Japanese, whose currencies at one point were down 10.2% and 7.7%, respectively. The Dollar index spot rate was up 9.6% and the US trade weighted currency index up 7.8%. In other words, this has been an indiscriminate lurch into the Dollar just as markets are beginning to show signs of economic weakness that could force a Fed U-turn.
Superficial analysis of EM – as usual
EM countries also have debt. How relevant are the Geneva Report’s conclusions for EM? The first point to make is that EM countries are much less indebted than developed economies. The authors’ own data shows that EM average government debt to GDP is 48% vs 108% for developed economies. EM countries also already ‘live’ with yields close to levels one would associate with ‘normal’ levels; EM countries finance at just below 7% in their local markets, which is roughly consistent with 10-year US treasury yields around 4.5%.
Sadly, the Geneva Report’s analysis of the debt situation in Emerging Markets suffers from the usual shortcomings. It only covers 21 EM countries out of a total EM universe of more than 160 countries (even the JP Morgan EMBI index now has more than 60 countries) and covers only the most advanced (and therefore most leveraged) EM countries, whose financial conditions are not very representative of the EM universe.
Broadening the scope to cover more EM countries means losing direct comparability. For example, many lower income EM countries have no data on household debt, though in most cases households in lower income EM countries are almost certainly far less indebted than households in higher income countries. Distinctions between tradable and non-tradable debt also fall away as does a comprehensive picture of financial sector debt, though in most cases lower income countries will also have much less of those types of debt than higher income countries. We have data on government and corporate tradeable debt in 58 countries (shown in chart 3 below). The data shows EM government and corporate tradable debt combined averages less than 50% of GDP. Only one third of EM debt is external, which makes a difference when it comes to vulnerability to tightening in US rates because correlations between local yields and US treasury yields drifts towards 0.3 after three months and the long term correlation is zero.
If one broadens the sample to the full universe of EM countries (where there is only public sector data available), the IMF data shows that the average public debt to GDP ratio in EM is just 34% (versus 108% in advanced economies). In other words, while the picture is not directly comparable it is nevertheless clear that the debt situation in EM is hugely stronger than that of developed economies.
The recurring China story
The Geneva Report’s conclusions about EM are also heavily influenced by China. But China is in many ways very unrepresentative of EM, or any other country for that matter. There are good reasons to be less concerned about China’s debt stock. Combined, the stocks of public and private debt in China measure 217% of GDP. This is high by EM standards, but note that government debt is a modest 49% of GDP. More importantly, China has an extraordinarily high gross national savings rate of 50% of GDP, which means that deposits in the Chinese banking system are at a high level of 160% of GDP. High private lending by Chinese banks reflects this high level of funding via deposits.
The leverage in the banking system – a key risk parameter – is actually quite low (217% over 160%). Thus China is far less risky than its overall debt level would imply. Indeed, we think China’s onshore government bond market in particular is one of the most interesting bond markets in the world today.
For EM, the Fed’s recent hawkish tilt interrupted, but did not reverse the recovery from last year’s sell-off. The normal pattern of recovery after an irrational sell-off is for external sovereign debt markets to rally first – this has happened already with external debt up just under 8.5% year to date. The next stage is usually for corporate and local bond markets to outperform, but these markets have been interrupted by the surge in the Dollar and the weakness in US high yield (HY). External debt has also given up some gains from earlier in the year (spreads have widened about 60bps to 299bps, an attractive entry level in our view).
EM corporates have held up well, maintaining their spread above Treasuries close to 500bps despite a significant sell-off in the US HY market. The relative outperformance of EM HY over US HY is justified, in our view. After all, until recently the US HY market traded at half the spread per turn of leverage of identically rated EM corporates. The US high yield sell-off has mainly had the effect of delaying spread compression in EM corporate space, in our view.
Interestingly, local bond yields have been well-behaved throughout the Dollar rally. EM local currency government bond yields are sitting around 6.7%. This is an attractive yield which has historically been consistent with much higher levels of interest rates in the US. Those investors who liked local bonds before the surge in the Dollar should like the market even more now.
