The flow through to EM equities

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.