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Cyclical emerging assets: after the euphoria fades, pragmatism usually takes over

The essential

Cyclical emerging assets (equities, currencies) are again deteriorating after this summer's crash. There is a strong temptation to consider an increase in risk exposure to equities and/or currencies. Meanwhile the Fed has to tread carefully to avoid causing volatility, which at this stage of the cycle would be very unwelcome.

We contend that only further bad news from China would derail emerging equity markets once again. In the short term, a cyclical low has been reached through more reasonable growth expectations. This is what the combined behaviour of currencies, equities and commodities illustrates.



The emerging markets after a second low point

Following a decent beginning of the year for emerging market equities and sovereign debt in USD, the trends reversed to culminate in an abrupt fall in August followed by a further, but less sharp, decline in September. Recorded performance in dollars was clearly negative from the outset, with a decline of 17% in local debt, a 13% drop for Frontier Emerging Market equities and a 7% slide for the main emerging equity markets. This compares with a decline of more than 19% in energy sector equities. Given the scale of these movements, the temptation to increase exposure again is strong. We would argue that in the short term a cyclical low point was reached via much more reasonable growth expectations. This is what the combined behaviour of currencies, equities and commodities illustrates.

The three main risks facing the emerging markets

The emerging markets are currently facing three main risks:

  1. corporate leverage in emerging Asia, to which the IMF has dedicated an entire chapter in its Stability Report1,
  2. the consequences of the sharp decline in the price of oil and, lastly,
  3. the normalisation of interest rates by the Federal Reserve.

These three risks are not independent of each other. The normalisation of the Fed's interest rates confirms the relative improvement in the growth prospects of the advanced economies and the United States in particular. This will inevitably diminish the appeal of emerging assets. Investors will be likely to demand higher returns before accepting the carry of a financial risk related with these economies. At the very least, this could lead to higher borrowing costs for these economies’ private and public sectors.

Anatomy of the recent increase in risk aversion

The current environment is conducive to continuing substantial pressures on emerging risk premia. Moreover, it is possible to monitor the trend in risk aversion by looking at the behaviour of the premia demanded by investors on a country basis and over a broad sample of assets. As graph in the box shows, this indicator comparing the main stress episodes since 2007.

Looking at 2013-2015, i.e. since the Fed began its odyssey toward more orthodox monetary policy, two observations can be made. The dollar tantrum, namely the stress that occurred in the second half of last year due to the sharp appreciation of the dollar, was shorter but more intense than the taper tantrum. Secondly, emerging market stress never really fell back to its summer 2014 level. After falling early in the year, it has been steadily growing since the end of the first half of 2015.

The difference between these two episodes lies in the factors contributing to the increase in aversion.

  • During the dollar tantrum, most of the rise was due to widening credit spreads and downward pressure on currencies
  • In the current stress episode, all asset classes have been contributing.

These premium adjustment patterns raise a question. Is there a risk of seeing a negative spiral develop? It would be a spiral in which higher spreads would lead to downward pressure on currencies due to capital outflows, which in turn would again lead to increasing spreads because of the automatic increase in foreign debt servicing costs.

A simple risk aversion indicator

  • It is possible to monitor risk aversion trends by observing the behaviour of the risk premiums demanded by investors or even ex ante risk premiums over a wide range of emerging assets – currencies, local interest rates, sovereign and corporate debt in dollars and equities. We computed these premia for eighteen economies: South Korea, India, Indonesia, Malaysia, the Philippines, Thailand, Poland, Hungary, the Czech Republic, Romania, Turkey, Russia, South Africa, Brazil, Mexico, Chile, Colombia and Peru. We shall present these statistics for each country in a next publication.
  • We hold the view that a rise in risk aversion occurs when the risk premium is above its 12-month rolling average. The average deviation of the risk premium is expressed as a standard deviation since it represents average deviation from the mean.
  • The risk aversion indicator is defined as the sum of deviations from the mean of the different risk premiums. It is constructed using weekly data going back to 2007.
  • We define the risk premiums as equal to the spreads of sovereign or corporate debt. We use the EMBI indexes (Emerging Markets Bond Index) for sovereign debt and the CEMBI indexes ( Corporate Emerging Markets Index) for corporate debt. In order to facilitate the understanding of these spreads, we express them as a percentage of US 10-year rates. For local rates, we consider the term spreads over the 2-year/5-year and the 5-year/10-year segments. As to currencies, we use the term spreads of the volatility curves over the 3-month/6-month and the 6-month/1-year segments. Lastly, for equities, we use the price-equity ratio.


The prospects for a more aggressive Fed than initially predicted are vanishing

For such a spiral to develop, a substantial deterioration in global liquidity conditions or a sharp downward revision of growth prospects would be necessary. In fact, in today’s risk spectrum, two o f them stand out: Fed interest rate normalisation and the Chinese slowdown.

As to the first of these risks, in our opinion, it seems well priced in. Firstly, because the Fed took pains to announce normalisation two years ago and to state that interest rates would rise only gradually. In addition, the last FOMC statement explicitly mentions taking readings on international financial developments into account.

For the emerging markets, the appeal of US long term rates is a critical factor. Any increase in the term spread – the difference between the short-term and the long-term interest rate – via a rise in long bond yields (bear steepening) would be highly adverse. In our view, an increase in this term spread is not very likely while release after release of employment statistics underscores that the pace of job creation in the United States is running out of steam.

Although the US economic environment remains a crucial component of global growth prospects, a moderation in its growth may avoid monetary tightening beyond what was originally projected and an unwanted rise in US long bond yields. As a result, this environment is fairly favourable for the stabilisation of emerging spreads.

The expectations surrounding China are becoming more reasonable again for lack of rationality

The question of China’s slowdown remains. Its scale has provoked a numbers battle among the experts, who are trying, in a fierce competition, to produce a growth number more in line with the reality of the country's current economic performance2.

Paradoxically, what actually matters, at this stage, is no longer China’s exact growth figure but what investors have factored into their assumptions. So as to figure it out , we tested and estimated a cointegration relationship between three statistical series assumed to be extremely sensitive to Chinese growth prospects: a composite index of emerging currencies, the MSCI Emerging Markets Index expressed in dollars and spot cash commodity prices via the Commodity Research Bureau Spot Index.
Our first observation is that statistical tests3 confirm that a relationship exists between these three series. In other words, omitting statistical inference, these three asset classes – emerging currencies, emerging equities and commodities – tend to be strongly correlated in the sense that a significant divergence in the behaviour of one of them compared to others is not sustainable for long.

Our second observation is that the “equilibrium price” of a kind of composite asset formed by emerging market equities in local currencies (equities in dollars + foreign currencies), derived from the cointegration estimated before, displays a high sensitivity to Chinese economic indicators – the graph opposite shows the gap between order book and inventory components in the NBS manufacturing survey4. It is remarkable that this price skyrocketed early in the year due to higher equities prices, in total opposition to faltering manufacturing indicators since the dollar began to rise in the summer of 2014. Since then, this equilibrium price has sharply corrected while, at the same time, Chinese industrial indicators seem to suggest that a cyclical low point was reached. In other words, at this stage, market expectations concerning the outlook for Chinese economic growth have become more reasoned, if not more reasonable.

Under the assumption that major credit accident will not occur, these emerging cyclical assets have, in the short term, become more attractive. A cyclical bottom should be reached in the coming weeks. Yet, it is too early to call it a day as it is going to be very hard to predict how private sector debt reduction will unfold in the emerging economies. This is a continuous challenge that should remain a focus of attention by central banks and major institutions alike, such as the IMF and the World Bank.


1 IMF October 2015, GFSR Report, Chapter 3: “Corporate Leverage in Emerging Markets—A Concern?”

2 In an insert on Tuesday 29 September on “FT BIG READ - China Statistics: Making the numbers add up”, the Financial Times made public the dispute between Carsten Holz, economics professor at Hong Kong University of Science and Technology, and Harry Wu, economics professor at Hitotsubashi University in Tokyo, over the quality of China's real growth figures.

3 We used the Johansen test.

4 NBS: National Bureau of Statistics, the official Chinese statistical agency.













The emerging markets are currently facing three main risks: corporate leverage in emerging Asia (...), the consequences of the sharp decline in the price of oil and, lastly, the normalisation of interest rates by the Federal Reserve





For such a [negative] spiral to develop, a substantial deterioration in global liquidity conditions or a sharp downward revision of growth prospects would be necessary





Paradoxically, what actually matters, at this stage, is no longer China’s exact growth figure but what investors have factored into their assumptions







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BEN ABDALLAH Marc-Ali , Senior Analyst, Investment Solutions
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Cyclical emerging assets: after the euphoria fades, pragmatism usually takes over
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