Friday, August 23, 2013

Developed markets growth improvement vs. busting EM bubble

I have been looking for higher safe yields in Europe and the US for some time now and also expected a growth improvement of net-commodity consuming developed markets vs. the rest of the world. In early July I concluded (see: H213: Limited systemic risks, low inflation & relative DM vs. EM growth improvement): "Those countries and markets which have been supported heavily by capital flowing out of the US and Europe (i.e. commodities, EMs) are most at risk of a significant underperformance as the combination of weakening fundamentals and the potential for a tighter monetary environment amid capital outflows demand its toll. On the other side, US, Europe and Japan should see a supportive mix of improving growth and an ongoing growth supportive monetary environment. In turn, risky assets and currencies of the EM/commodity producing world should continue to be sold on uptics whereas developed markets’ risky assets as well as US/European fx should be bought on dips. However, safe nominal and real yields have seen their lows and moved back on a rising path, especially in the US. "
This conclusion remains fully valid and the current market movements (higher nominal yields, higher risky asset prices and higher currencies in the Eurozone, UK and the US on the one side, lower currencies and risky asset prices in EM and commodity producing countries on the other) promise to run significantly further.

To escape the US Great Recession and the sovereign debt crisis in Europe, capital has flown into emerging markets and commodity producing countries in previous years. It helped fuel growth, inflation and indebtedness and thereby lead to worsening fundamentals in the capital receiving countries. As systemic Eurozone risks have abated, growth in Europe and the US is improving and real yields are rising, this capital is now flowing back, exposing an environment of worsened fundamentals in the EM/Commodity producing countries.
Even though their currencies are plummeting, the capital outflow constitutes a net monetary tightening in the affected emerging economies as credit availability shrinks and rates are rising. Moreover, several emerging markets face the problem that a lower external value of their currencies translates mainly into higher inflation and not higher external competitiveness. In order to prevent further capital outflows, some countries have already reverted to rate hikes (thereby further tightening monetary conditions) and/or started to buy their own currency with the help of foreign reserves (which, however, tends to reduce liquidity in the domestic financial system). Also the currencies of developed market commodity producers (i.e. NOK, AUD, CAD) continue to be at risk. These countries see a deterioration of their fundamental outlook amid the end of the commodities super cycle. Furthermore, they have been at the receiving end of large sums of capital flowing out of the Eurozone and the US as well which now might increasingly flow back. Finally, they were also beneficiaries as central banks increasingly diversified their reserve currencies over the past years. As reserve accumulation goes into reverse, though, this support evaporates. Hence also in this case fundamentals suggest a deteriorating environment. The difference to emerging markets is that the respective central banks tend to accept the lower external value of the currency and can even react with rate cuts as for example in the case of Australia. As a result, instead of performing pro-cyclical policies into the slowdown as in a number of emerging markets, they have the ability to enact counter-cyclical measures. Nonetheless, as growth is weakening and capital is flowing out, there is more currency weakness in store.
For the Eurozone, the UK and the US the reversal of capital flows constitutes monetary easing and should lead to an improvement in credit availability over the medium term. Therefore it counteracts the growth negative effects from higher yields and higher trade-weighted exchange rates. In turn, the trends of higher yields and stronger currencies promise to run further on a strategic time horizon (i.e. on a 6-9m view to Q1-Q2 2014) and the respective strategic positioning (shorts in safe bonds, longs in EUR,GBP,USD) should be maintained. Spreads of higher-yielding semi-cores and peripheral bonds should see a sideways to tighter trading environment given that higher growth improves their creditworthiness amid a better outlook for the debt-GDP trajectory.
However, the dislocations in emerging financial markets have the potential (via weaker growth and weaker currencies) to lead to lower export demand for the developed markets and might in conjunction with fears surrounding the Fed’s tapering temporarily lead to higher risk aversion. Within fixed income, this could potentially have the largest effects on corporate bonds. For one, a large number of corporates has profited significantly from the booming emerging and commodity producing countries. Furthermore, corporate bonds in general have been in good demand over the past years as a means to escape the sovereign debt crisis. Hence, risks are for a partial reversal of these flows and sovereign bonds should be preferred to corporate bonds.

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