For traders, 2018 has been a year of two narratives: a relatively stable rebound in the US after the February near-correction amid stellar corporate earnings, while the rest of the world has seen what Morgan Stanley has dubbed “a series of rolling bear markets.” In fact, while one wouldn’t know it looking at US stock markets, on an equal weighted basis, the average of global stocks is now down 14% from from its January 2018 highs.
But more to the point, virtually every month of this year so far has been defined by a specific theme: after the market melt-up in January, the “Vixplosion” in February, US LIBOR surging in March, inflation worries in April, Italy stress in May, trade fears in June and tech tumult in July, the latest “nemesis” is the plunge in EM currencies.
Commenting on these moves, BofA Barnaby Martin writes that “the common thread with all of these “shocks” is that they are symptoms of a world characterized by desynchronised growth, politics and liquidity support” and adds that the instigator of this backdrop in 2018 has been the rise populism to levels not seen since World War II, a phenomenon which prompted Deutsche Bank to write that “the liberal world order is in jeopardy.”
So as we continue our trek through the summer doldrums of August – which have been anything but boring – here is what Bank of America believes are the key charts to watch “in a frantic August.”
Chart 1 shows the path of currency devaluations (vs. USD) in previous EM events. So far, the Turkish Lira devaluation looks nothing out of the ordinary. But history suggests that weakness can last for many more days. The probability of orthodox policy adjustment in Turkey looks low at present, with a hard landing scenario looking more likely.
Chart 2 shows USD fixed-rate debt outstanding in BofA’s EM external debt index. Note that it shows both corporate and sovereign debt. While Turkey’s quantum of USD borrowing is clear, it is still eclipsed by China, and the Asia Pac region.
Nonetheless, chart 3 highlights Turkey’s specific vulnerabilities: Turkey’s external borrowing as a % of GDP is much more noteworthy. In particular, private sector external debt/GDP has grown at a very fast rate as a result of recent privatization tenders and large infrastructure projects which were run as public-private partnerships (PPP).
Chart 4 shows how the pace of USD-denominated borrowing by Emerging Market non-banks jumped from early 2010. The Fed’s QE era provided ample financing for companies that were not natural funders. Lately, the pace of USD-denominated borrowing has declined for non-financials in (developing) Europe (-6% YoY), yet growth rates remain high for non-financials in (developing) Africa (+19.9% YoY) and (developing) Latam (+9.4% YoY).
Chart 5 shows the growth rates of non-bank USD-denominated foreign debt, by borrowing type. Pre-Lehman, amid a vibrant banking sector, foreign currency credit was most readily available to corporates via loans. The growth rates of USD-denominated loans reached 40%. Things changed, understandably, post the financial crisis as banks deleveraged and moved back to their domestic markets.
Since 2016 however, the growth rate of USD-denominated loans to non-bank Emerging Market corporates has remained very close to zero. Yet, the growth rate of USD-denominated debt securities outstanding has jumped to almost 20%.
Again, while and era of global QE has revitalized the bond market, it has also attracted debut issuers for funding.
An orthodox response by an Emerging Market central bank to currency weakness is often to hike interest rates (note Argentina has hiked 7d repo rates from 27.25% to 40% this year). But as 2018 has progressed, this has become a more frequent occurrence. As we noted earlier, the next chart shows that the cumulative number of central bank rate hikes over the last 6m is now not far from the peak seen just prior to the Lehman event. In other words, the world has seen a significant liquidity withdrawal since May this year. This suggests less “crowding” by investors into risky assets lies ahead.
Meanwhile, the USD has continued to strengthen in August, and the ongoing Dollar strength remains a negative for European markets. As chart 7 shows, retail inflows into Euro credit funds have fizzled-out this year, and this has coincided with the period of Dollar strength from March ’18 onwards. Coupled with very attractive front-end rates in the US, European retail money is simply leaking to the US market at present.
In the context of “rolling bear markets” not all volatility measures have moved in sync this year, despite ongoing dovish and transparent central banks. Rates vol remains close to its start-of-year level. But note the surge in Emerging Market FX volatility this month.
As chart 9 shows, the jump in EM FX volatility is starting to make credit spreads in Europe look on the rich side now, as High-yield, in particular, has had a historically high sensitivity to Emerging Market stress.
Much more attractive EM valuations pose a relative value headache for credit markets. BofA strategists have recently looked at the tightness of US high-yield spreads and argued that pricing poses a modest headwind to performance at the moment. The last chart shows widening EM spreads amid a sideways US high-yield market.
Finally, Martin claims, and shows, that the European credit market has been rather inefficient, thus far, in reflecting higher EMFX volatility in credit spreads. As shown in the chart below, there is hardly any link at present between the EM sales exposure of European credits and their CDS underperformance, of late. This is much more the case for non-financials than for financials, as spreads for financials have been quicker to widen on EM FX concerns.