The deterioration in emerging markets and junk bonds in recent weeks is hardly a surprise but it is now certainly grabbing the attention of the mainstream media.
The initial catalyst for the plunge in prices this month is the collapse in the price of oil. Unsurprisingly, energy producers in the emerging world and in the corporate world are under severe pressure. However, the underlying issues have been building for some time. The chief culprit is the strong US Dollar and the lack of new Dollars being supplied into the global system. This combination has been slowly throttling emerging market growth and making it increasingly difficult for those who have borrowed in US Dollars to service their debt. The oil price collapse is symptomatic of a lack of global demand and has clearly brought into focus the frailties of high cost producers.
As noted above, emerging markets are being starved of US Dollars. Most global trade is transacted in US Dollars and therefore, unless the US consistently grows its current account deficit, global growth has to suffer with emerging markets suffering the most. Post the financial crisis, the US current account deficit never grew because of the shale energy revolution. What happened instead was that the US Federal Reserve embarked on massive QE which encouraged outsized portfolio flows into EM bonds and loans. So, rather than financing trade and growth via an ever increasing US current account deficit, EM growth was financed by trillions of Dollars of portfolio flows.
One of the obvious outcomes of the end of QE is the drying up of "hot money" portfolio flows into emerging market bonds. The potentially destabilising event that happens next is that investors who have lent to the emerging markets want some of their money back. This is a simple sentiment and momentum event. For as long as investors were making money in a low volatility way, they were happy to keep their EM debt. Now that it appears that certain issuers will struggle to repay their loans, and the price of bonds is falling and volatility is rising, investors are beginning to question their investments and may want their money back. As noted in previous weekly comments, the structure of the market is incredibly fragile, and even small sell orders can cause relatively large price falls. The exit door from EM debt is closing rapidly and an avalanche of sell orders could easily result in panic price declines.
Another obvious outcome of QE was that it enabled US companies to issue record amounts of debt. In some cases, debt was used for investment, such as in the energy sector which accounted for fully 40% of all US corporate investment. In some cases, debt was used to buy back shares, which adds nothing to economic growth. In nearly all cases, the standard of covenants on the newly issued debt and the return to investors have declined dramatically. Now that QE has ended, and high yield and junk bond prices are falling, the US corporate bond market is likely to be seen as extremely fragile in a similar way to emerging market bonds. Furthermore, bond issuance will dry up, thereby squeezing corporate investment and share buybacks, ultimately hurting economic growth and taking away massive support for US equity prices.
If all of the above sounds a bit bearish, well it is. Financial markets have been pumped up by central bank policies for years. Economic growth, which is what ultimately generates the cash flow to service bond payments and generate returns to shareholders, has been anaemic. Just as in 2007, if debt defaults reach a tipping point, and price declines in markets cause a shift to bearishness, then it is highly likely markets are headed for another nasty bear market. So what could avert such an outcome?
In economic terms, an increase in growth and consumer incomes would obviously help, and of course many are hoping that the US$1 trillion + wealth transfer from energy producers to consumers and business will help. In the long term it will help, but in the short term, default risks are rising and markets are already seeing sharp price declines. Quite simply, the only positive outcome is likely to come from more central bank stimulus.
Next week, the US Federal Reserve meets, and seems more likely to talk about their strategy in raising rates next year than resurrecting QE. The ECB is struggling to move to outright QE, and is potentially being stymied by the deteriorating political situation in Greece. We are assuming that the ECB will not start QE before March, by which time it may be too late.
We believe that global financial markets are extremely fragile at the moment, and a further deterioration in sentiment could easily lead to further sharp price falls as investors look to reduce risk in increasing illiquid markets. We don't see central banks as being in a position to appease markets at the moment, and it is quite possible that much more pain needs to be seen before either the Fed or the ECB step in to support prices.
The price action has been extremely bearish in many emerging market assets and currencies, and lower quality corporate bonds. Developed equity markets have become more jittery and ended last week on a sour note. From our perspective, holding equity put options and US Dollar call options in the RMG Real Return Fund is the best risk versus reward way to position for further price declines and increasing volatility.