When investors fail to secure sufficient compensation for bearing illiquidity, they almost always come to regret it. The summer reaction of certain asset classes to the Fed’s suggestion that it was considering reducing the pace of its bond purchases exposed vulnerabilities for the future. list of domains . The US-centred bond market sell-off in June caused notable stress in emerging markets. This stress was most visible in ETFs that invest in emerging market debt where some banks and intermediaries were unable to meet immediate redemptions from their clients.
Emerging Market Local Currency debt is a good illustration of just how tight pricing has become. Local currency bonds typically offer a positive spread over developed markets and this spread is a function of a number of factors including credit risk and illiquidity premium. Market participants often underestimate the illiquidity premium component in earning their yields. The traditional appeal of Local Currency bonds is their traditionally higher yields, price increases with improved credit quality, diversification in a global portfolio and the potential for currency appreciation. The illiquidity of these instruments and return for this illiquidity that investors must demand has been all but forgotten.
We expect to see more attractive levels for emerging markets over the coming quarters for three reasons. First, emerging markets will face strong headwinds as this period of quantitative easing slowly comes to an end. A further re-pricing of the US risk free rate is unlikely to be a smooth and ordered process for emerging markets and the liquidity premium is likely to rise. Second, valuations for emerging market stocks and bonds do not appear to be especially attractive at these levels by historical standards. Finally, although there has been some capitulation in the asset class we do not appear to have had a proper capitulation from slower money. This final capitulation would ordinarily suggest a bottom may have been reached. The optimal expression for us is to hedge by being long the USD against an EM currency basket consisting of five emerging countries selected for having the lowest ranking on current accounts and purchasing power parity.