The flow through to EM eq­ui­ties

Financial Mirror (Cyprus) - - FRONT PAGE -

Th­ese are strange times for in­vestors with bond yields in big de­vel­oped mar­kets plumb­ing new depths on dark con­cerns about never end­ing de­fla­tion and stag­na­tion. Yet in a clearly re­lated de­vel­op­ment, US eq­ui­ties are mak­ing new highs while cor­po­rate- and emerg­ing mar­ket-bonds con­tinue to rally. There are blind­ingly ob­vi­ous con­tra­dic­tions within th­ese par­al­lel as­set price move­ments, but with­out get­ting into the tor­tu­ous busi­ness of squar­ing cir­cles, the real ques­tion is whether we have moved into a new in­vest­ment en­vi­ron­ment which will re­quire a lot of in­vestors to fairly swiftly read­just their port­fo­lios.

A few months back the propo­si­tion was raised that the rally in deep cycli­cals since Fe­bru­ary re­flected the lead­ing edge of a new in­vest­ment en­vi­ron­ment dic­tated by two big devel­op­ments; namely the top­ping out of the US dol­lar and the re­al­i­sa­tion that China’s econ­omy was not about to be re­vealed as his­tory’s big­gest Ponzi scheme and col­lapse. As a re­sult, in­vestors were ad­vised to fo­cus their at­ten­tion on two key ques­tions:

· Is the US dol­lar done ris­ing and in­stead en­ter­ing a phase of flat-lin­ing or even de­pre­ci­a­tion?

· Are emerg­ing mar­ket bond yields (to a great ex­tent a play on China col­lapse con­cerns) done ris­ing and about to de­cline?

Clearly an an­swer to both ques­tions in the neg­a­tive pointed to in­vestors favour­ing bal­ance sheet strength, in par­tic­u­lar US growth stocks, which un­til early this year was pre­vail­ing mar­ket wis­dom. But an an­swer in the af­fir­ma­tive pointed to a dif­fer­ent out­come, which promised im­me­di­ate re­lief for those com­pa­nies, es­pe­cially in emerg­ing mar­kets, with stressed bal­ance sheets. Af­fir­ma­tive an­swers sug­gested that in­vestors should move out on the risk spec­trum and load up on such lower qual­ity as­sets.

In the in­ter­ven­ing pe­riod, mar­kets suf­fered a de­fla­tion­ary shock with last month’s Brexit vote, which in the nor­mal course of events should have spurred a ma­jor pre­cau­tion­ary move into the US dol­lar. Yet, while the dol­lar has ral­lied in re­cent weeks, at least on the trade-weighted DXY mea­sure, it re­mains within its trad­ing range. It is also worth not­ing that emerg­ing mar­ket cur­ren­cies are well above their Fe­bru­ary low and only a shade be­low their one-year high.

Now, granted mar­ket ac­tion hardly sug­gests that in­vestors should be po­si­tioned squarely for a risk-on en­vi­ron­ment. A cu­ri­ous bar­bell has emerged with safe-haven as­sets such as trea­suries, gold and gold min­ers, do­ing de­cently well at one end, while at the other ex­treme, com­mod­ity-de­pen­dent emerg­ing mar­kets and other deep cycli­cals have of­fered some of this year’s best re­turns. This dis­so­nance is dis­con­cert­ing and raises ques­tions about whether the next move is into the abyss, or a gen­tle as­cent to­ward sun­lit up­lands. How­ever, on the ba­sis that the cur­rent en­vi­ron­ment re­mains in­tact a while longer, it is log­i­cal to ex­pect a flow through from the repric­ing in emerg­ing mar­ket debt to other as­sets.

It is worth not­ing, for ex­am­ple, that sin­gle-B rated Chi­nese prop­erty de­vel­oper bonds a year ago yielded 11-13%, but now of­fer 5%. Yet de­spite their cost of fund­ing hav­ing halved and the out­look for the Chi­nese prop­erty mar­ket hav­ing sub­stan­tially perked up, the share prices of many such firms have barely moved, and in some cases fallen. Should the com­pres­sion in bond yields con­tinue, and that is cer­tainly the trend across emerg­ing mar­kets, then it is hard to imag­ine no re­sponse in as­so­ci­ated eq­ui­ties.

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