Emerging Market Debt: Showers & Flowers
The full ugly
2022 has been a brutal year for emerging markets (EM) debt, with more than USD 50bn flowing out of the space, much of which packed bags and left in a hurry in the early summer. June was especially ugly: The combination of financial conditions, Chinese lockdown, and the potential for unrest as food prices spiral has combined to put fear into the emerging market investing public. When the Fed announced a 75bps hike in early June, it unleashed a vicious technical sell that would be almost comic were it not so severe. As redemptions accelerated, investors in hard currency debt sold their over weights to flatten portfolio risk. Consensus longs went from market darlings to sells as outflows turned a drawdown into a bear ascendancy. A feature of emerging market meltdowns is that the sublime can become the ridiculous, and this beat down was no exception. Consider the long ends of two curves: BB rated Mexican oil giant Pemex, and Erdogan’s single B rated Turkey. One is wholly owned by investment grade Mexico and produces oil; the other imports nearly all its energy and is experiencing eroding economic fundamentals. Recall that it was Erdogan who famously blamed Turkey’s persistent inflation problem on higher interest rates, a view that may help explain Turkey’s currently accelerated inflation rate. Turkey often underperforms Pemex, but these are unusual times: the Turkish long end has instead outperformed Pemex by 150bps year to date. The reason why Pemex has underperformed is mostly due to it entering the year as a consensus overweight, and thus has been recently well offered by managers experiencing outflows.
Figure 1: These are not normal times
From showers come flowers
There comes a point in every drawdown where pain becomes an opportunity. Hence our ears pricked up when our dealing desk spotted abnormally large trades going through the market – indicative, they said, of institutional portfolio inflows. Since the sell side are a talkative lot, it didn’t long for us to learn that several US institutions were rotating out of other asset classes into the space. That is the first real buying we have seen in several months, and we think it important as it challenges the present flow pattern.
What may be motivating these trades is a strong valuation argument. We asked our Quantitative Solutions team to compare the space’s current valuation with other historic drawdowns, mindful of the feeling that trading in the ’22 market feels a lot like the ’08 example referenced below. What we found was confirming: in emerging market sovereign high yield, the present yield-to-worst (YTW) is 2.64 standard deviations wider than normal – versus 2.77 standard deviations in October 2008, when the global banking crises was in full swing. Things may look challenging in EM currently, but they are nowhere near as bad as they looked in 2008, so this has the appearance of an overshoot. Even more interesting is that EM Sovereign Investment Grade (IG) is nowhere near the equivalent level: it trades at 0.21 standard deviations of YTW, while during the ’08 event, IG reached 3.55x standard deviations beyond normal YTW. That divergence might speak to the increasing institutional sponsorship that underpins the investment grade arena, but it also says that there is a bid for quality in the EM space.
Figure 2: This is ridiculous
This matters for two reasons: first, as the Quantitative Solutions team points out, when the standard deviation goes over 2, the underlying space tends to go on to do quite well. And second, the brave souls who bought EMD in 2008 – the peak ugly buy – went on to make a 125% compound return over the next 8 years as the space feasted on quantitative easing. We are not suggesting that EMD is cheap at present levels (125%), but we are highlighting that the current pricing is approaching once in a decade levels, and that 2022’s price action has created substantial value.
Spreads in EM Hard Currency debt support this view. We recently looked at the relationship between historic spreads and subsequent returns. In our analysis, we found subsequent performance to current spread levels is commonly quite strong. In Figure 3, The histogram shows that the average return over a one year period from the current spread level approaches returns generally seen more in equities than bonds.
Figure 3: Historical returns for EM Sov spread > 550bps
If June’s performances were capitulation, and the flow reversal has been achieved, then JPMorgan EMBI Global Diversified Index’ s current 8% yield to worst is unlikely to last forever. It doesn’t take a lot of flow to snap back emerging market performance, and the valuations appear ripe for a rally. What the catalyst proves to be remains to be seen. In 2008, that catalyst was a policy decision, and it went on to unleash an eight year long bull rally. At that time, the fundamentals were also far from perfect, but the valuations were ridiculous. With high yield spreads over 1000bps, JPMorgan EMBI spreads (including IG) are now over 500bps, suggesting that we are in similar territory now.