Ok, so I’m not entirely sure how to frame this in light of how emerging market assets have performed this year, but I’m pretty sure it’s really interesting.
One of the big themes we’ve latched onto and perpetuated over the past couple of weeks is the extent to which EM assets have been largely bulletproof in the face of things that should, by all accounts, cause problems. Things like what’s supposed to be a Fed tightening cycle, tightening in China, and plunging commodities. Here are some of the relevant posts:
- This Is A Disaster Waiting To Happen
- “This Does Not Bode Well”: One Bank Warns “The Chinese Monetary Put Is In Reverse”
- Here’s Another Example Of Stocks Not Caring About The Big Picture
Our contention (and the contention of more than a few other folks) is that this resilience has a lot to do with the relative stability of the yuan. To wit:
But we’ve also warned that in addition to the potential land mines listed above, there’s also a bigger picture argument for why EM could soon roll over and that argument looks like this:
There’s a counterargument to that chart which we’ll present at some point this weekend.
All of that said – and this gets us back to what we noted at the outset – Citi says we’re missing something. Namely that outward appearances (i.e. prices) be damned, investors are actually hyper-focused on “all that can go wrong with EM.”
Read more from the bank’s note below.
What the Fear Gauge Doesn’t Tell You About EM
It seems not a day goes past without a newsflash coming across the screen telling us that the VIX is close to or now at an x- or y-year low, and that complacency therefore reigns in the equity world. Yet at the same time as these headlines appear daily, our interactions with investors regarding EM continue to resemble pushing the boulder up a hill. Sadly, the boulder does not have wheels on it, and the hill is a mighty steep one. The vast majority of meetings – regardless of the continent – continue to focus on all that can go wrong in EM.
China tops the list of concerns: excess leverage, private wealth products, etc. Then we have the latest worry: North Korea. For every 10 meetings, maybe 2-3 are constructive on EM, while the rest still look for reason to either not be in EM if you are a global PM, or to play defensive if you have an EM mandate. The VIX may signal complacency or blue skies ahead, but when it comes to EM, it is either still dark and we can’t see the sky, or the clouds look rather ominous.
The VIX and EM
The VIX is one of these instruments that can be used to construct a bullish or bearish argument depending on your preconceived ideas. So, if the VIX is high, stay away cause there is trouble at mill, as they say. If the VIX is low, again stay away, because investors are so complacent that something bad is bound to happen which will surprise to the downside.
Figure 1 looks at the VIX index and the book yield of EM (inverse of the P/BV). Post-1997 (the Asian/EM crisis), the relationship has always held reasonably well: VIX low and book yield low (i.e. P/BV has been high). When the VIX has been high, then EM has tended to trade at a low P/BV. EM was cheap, but few bought it because the VIX was high and as such there were risks out there! The valuations suggests the market knew that too.
What is interesting is that since 2012, we have seen divergence between the two series. VIX has continued to move lower, but until very recently, the valuations in EM have failed to follow the VIX lower. Granted there aren’t many data points but historically, the P/BV for EM would have been 2x rather than the 1.6x the asset class trades on currently for the same level of the VIX.