It has long been observed by eminent practitioners that the market really represents nothing more than a pendulum that swings back and forth through the median line of rationality spending little time at the point of rationality and most of the time on one side or the other.
In August last year we wrote that emerging market debt and currencies appeared overvalued and had further downside in aggregate. We identified vulnerable countries as those having both a poor external funding position along with low reserves. Market prices have adjusted downwards in emerging market debt and currencies over the last few quarters making this a sensible time to examine current conditions. An historic darling of EM, Brazil illustrates the weakness: the Real has fallen by about 10 percent versus the USD since last summer and the 10 year bond has fallen by about 20 percent in price terms.
We prefer a disaggregated approach when examining emerging markets, but for the purposes of this paper we consider the asset class more broadly. We conclude that while prices appear fair today, we have not yet observed capitulation. There is still no margin of safety in the context of our base case of rising US real rates.
We constructed a composite basket of emerging market bonds comprising twelve countries from the three regions of Eastern Europe, Asia and Latam. We then compared the real yield offered in the marketplace against our theoretical real yield. We calculated the theoretical real yield by the summation of US real rates plus a credit risk premium for each emerging market country in the composite. Credit risk premium was observed by the credit default spread and inflation comprised the average CPI over the last three years, given the general absence of inflation linked bond markets to reference inflation in emerging countries.
Our conclusion on examining the data from 2002 is that there is a reasonable correlation between the theoretical and actual price offered in the market. There have been periods when the yields offered by the market are above those that our theory would suggest and periods when the opposite is true. Presently emerging market bond yields trade at almost the same level as our simple theoretical model would suggest. There is no margin of safety being presented in emerging debt at current pricing, particularly in consideration of our expectations for increasing real rates in the US over coming quarters. However, there is dispersion in the results and our analysis uncovered countries where the market rate exceeds the theoretical price.
A significant attribution of local currency debt comes from the currency exposure. Dislocations often occur with a sharp rise in volatility offering tremendous opportunity for those still not invested. We examined 1 month and 12 month implied FX volatility for a number of emerging market countries. There is dispersion in the results. For example, India is close to one standard deviation above its mean volatility and Columbia is more than one standard deviation below its mean volatility. The composite reveals that implied volatility is close to the mean value. Viewed solely from a volatility perspective, we do not appear to have had a dislocation event and volatility, in the composite, is not at any extreme value.
Implied Volatility Ranking
In aggregate, implied volatility does not suggest that we are at a point of extreme. However, as with the debt analysis, individually some countries appear at extremes. We conclude again that there are some opportunities when examined in our preferred disaggregated approach.
Our sample flow analysis for local market debt suggests that assets have dropped by 38 percentage points from the peak of cumulative inflows (since 2004) in May 2013 to the end of January 2014. This would appear significant but we need to place the data in context. Surprisingly, allocations into local markets since QE1 began have not even halved yet which could suggest there is more unwinding ahead. The prime beneficiaries of QE including EM debt could be expected to also suffer the most on the withdrawal of QE.
We conclude that on both measures employed – theoretical yields versus actual yields offered and implied currency volatility we might be at fair value. We do not yet perceive a margin of safety. The flow data also lends some support to this conclusion.
For a more detailed discussion on our disaggregated study, please contact Cerno Capital.