You’re a trader and what you thought when Brazil plunged headlong into yet another corruption scandal was something like this:
Gee, with EM priced to perfection and the Fed looking to tighten right alongside China’s efforts to squeeze their interbank market, EM needs a black swan-ish political crisis about like it needs a hole in the head.
But you’d be mistaken. Because when there’s no end in sight to the artificially suppressed vol regime, you have to be a carry trader. If you’re not, you’re an idiot. Throw in Treasury yields that can’t sustain a move higher and the resultant pressure on the dollar and you’ve got yourself a pretty good thesis for why EM is a priced-to-perfection asset that just may be able to remain bulletproof. Or at least that’s the way it seems.
That’s the context for some amusing commentary out of Barclays head of Asia currency and rates strategy Mitul Kotecha, who told Bloomberg the following on Monday:
There’s a wall out of money out there that continues to be flooding into emerging-market assets, looking for carry in a low-volatility environment.
Flows into EM assets persists despite this sort of news that you’d think would have the opposite impact on the currency.
With a relatively soft U.S. dollar, capped U.S. yields and low volatility, it’s hard to see this turning around anytime soon.
Famous last words for an asset class that’s stretched? Probably.
And especially if China can’t contain the inevitable fallout from its deleveraging efforts (if anything, the “cyclical adjustment factor” they just added to the yuan fix smells a lot like they’re worried about capital flight again).
Well for those interested in the longer version of Kotecha’s thinking on EM, here are some excerpts from his latest note.
Brazil has remained at the centre of the market’s attention over the past week. The situation remains fluid, but after the sharp correction across Brazilian assets late last week, markets appear to have found some footing. For Brazil credit specifically we argued that the country is in better shape fundamentally than it was during the 2015 political crisis. This, together with a more supportive technical backdrop for EM assets in general, should make Brazilian spreads more resilient than they were then. However, we believe Brazil local assets do not reflect sufficient risk premium. For example, the BRL remains about 20+% overvalued on our short-term and medium-term models.
For the broader market, the question of contagion naturally arises from the events in Brazil. We think there are three potential contagion channels.
First, sustained pressure on Brazilian assets will dent the overall performance of EM funds, threatening to break the virtuous cycle of positive performance attracting further fund inflows. Empirically, past performance appears a major predictor of future flows. So far, the correction in Brazil has not been sharp enough to drag down performance at the global index level significantly. While Brazil carries a meaningful weight in EM, MTD total returns of both EM credit and EM local markets are still positive. In the case of EM credit, Brazil’s 8.5% weight and – 1.3% MTD performance has contributed -0.11% to the overall index return of +0.25% (Figure 1), with Brazil’s negative performance offset by the positive performance of Mexico and Indonesia, for example (with the latter benefitting from S&P’s decision to upgrade the country to IG).
As a second channel, EM investors could become increasingly sensitized again to political risks, with negative sentiment permeating into other countries where political developments could carry negative market implications. We think that Latin America deserves particular focus in this context, with the ongoing crises in Venezuela and Argentina and Mexico heading into crucial mid-term and regional elections, respectively.
However, political ‘risks’ are rarely one-sided. For example, South African assets outperformed this week as it emerged that the ANC’s National Executive Committee may discuss the option of the party removing President Zuma at their 26-28 May meeting, related to the no-confidence motion called by the opposition in parliament (even if the motion seems unlikely to succeed at this juncture). Meanwhile, in Turkey, following President Erdogan’s return to the AKP leadership, talks of a potential cabinet reshuffle have gained momentum. The AKP’s priority will likely be the economy ahead of the presidential elections in November 2019. In this context and as discussed in local media, the cabinet role in charge of coordination of economic policies could be strengthened, which, if it materializes, may remind investors of the Babacan era and would likely support sentiment. For the longer term, however, we think that there has been a paradigm shift in AKP’s economic model recently, focusing on fiscal and quasi fiscal spending on large infrastructure projects and financing of SMEs, which in our view suggests an unlikely return to the economic framework the AKP pursued in the early years.
Finally, as the political turmoil risks adversely affecting Brazil’s growth recovery (we think a double-dip recession is now a material risk), there could be economic contagion, primarily to neighbouring countries. In the case of Argentina, we think that a double-dip recession in Brazil would likely affect growth in H2 17, primarily through trade..
Overall, we think while some negative sentiment effects and increased caution towards EM from the Brazil developments cannot be fully ruled out, the case for sustained contagion is weak and other parts of EM may even be able to benefit from re-allocations from Brazil. Indeed, markets appear to be acting in a manner that suggests they agree with this view. Risk appetite resumed following the speed bump emanating from Brazil, with investors quick to jump back onto the carry trade bandwagon.
China’s slowing growth trajectory and deleveraging remain issues that could pose risks to markets. There are growing concerns about the impact of deleveraging on China’s growth, commodity markets and related EMs. Although in line with our expectations, the downgrade of China’s credit rating by Moody’s highlights the lack of meaningful progress on SOE reform. Nonetheless China’s government is addressing mounting financial risks, something we believe will lead to higher interest rates over the medium term.
Oh, and speaking of markets viewing the crisis in Brazil as a “speed bump” rather than a veritable road block, flows into Brazilian stocks from global and regional funds summed to $760 million from May 19 through last Thursday. That’s the most in five years.
So yeah, “carry” on.