Just a quick note on emerging markets.
We’ve talked a lot lately about the extent to which EM credit weathered the storm a bit better than HY this month as Trump turmoil and heightened risk on the Korean peninsula catalyzed a bout of risk-off sentiment – or, perhaps more appropriately, “what counts as risk-off sentiment these days.”
This is a pretty important dynamic to keep track of. Generally speaking, a lot of the jitters we’ve seen in August are tied to Donald Trump and it’s no secret that his insistence on pissing off lawmakers is creating considerable uncertainty around the fiscal outlook in the U.S.
That, in turn, has weighed on the dollar.
So Donald Trump has been the proximate cause behind both dollar weakness and episodic flights to safety. Relatedly, it’s reasonable to assume that the more uncertain the fiscal outlook, the less aggressive the Fed will be, and that only adds to bearish dollar sentiment – we saw this reflected in the Fed minutes.
Given that the weaker dollar and a slow pace of policy normalization are key pillars of support for emerging markets, and given that the same thing that’s weighing on the dollar (Donald Trump) is also behind fleeting risk-off moves, it makes sense that EM would outperform USD HY.
There’s nothing particularly profound in the dynamic I’ve just described but it’s worth noting, especially considering the fact that given the juxtaposition between the large short base in EM CDX and the large long base in HY CDX it’s difficult to draw concrete conclusions about what it is we’re seeing in spreads.
Anyway, here are some brief excerpts on this from Barclays that I think are important, or at least worth skimming…
EM assets have continued on a steady path over the past week, amid seasonally low market activity. However, there are some obvious signs of nervousness: EM funds had their biggest week of outflows this year, last week, driven by outflows from EM dedicated equity funds.
Moreover, with some other risky assets’ performance having been volatile recently, including most equity markets and US HY credit, EM’s resilience has led to noticeable relative outperformance (Figure 1).
Tighter relative valuations naturally diminish EM’s buffers in any correction and make the risks from any unexpected, unfavourable developments more pronounced.