It is perfectly logical that the summer rally in emerging market debt was aborted the moment Powell spoke at Jackson Hole and risk assets plummeted on the expectations of ‘higher for longer’ interest rates and QT, which means the global money pump now goes into reverse. Apart from the predictable horror stories like Lebanon, Pakistan, Sri Lanka, Zambia and Egypt, even the JP Morgan tracker for this asset class (symbol EMB) has given back almost 5% of the 7% bull run it had between early July and the Jackson Hole bombshell. EM debt once again proves to me that markets go up like an escalator, but plunge like a demented elevator.
There are three reasons why I think it is insane to allocate capital to emerging markets at this point in time. One, I expect draconian monetary tightening once the soaring rents in the US are factored into the CPI data, since rents are 30% of the CPI index. Two, 20% rise in King Dollar since March 2021 is the kiss of death for dozens of emerging markets where deflation and cross asset contagion is imported via the current account deficit. Three, the Chinese economic supertanker has hit its property iceberg and the PRC is having its own Lehman moment, only a 100 times bigger in scale.
“Malaysia and Indonesia will be hit by the slump in Chinese demand for commodities, while South Korea/Taiwan exports will be slammed by the global tech slowdown”
EM debt is a proxy for global growth liquidity and China centric exports. This macro scenario is impossible in 2022 and 2023. For instance, Malaysia and Indonesia will be hit by the slump in Chinese demand for commodities, while South Korea/Taiwan exports will be slammed by the global tech slowdown. Afterall, Taiwan, South Korea and China make up 50% of the EMB index and all three countries could be firing drones and missiles at each other in anger if the geopolitics in the Pacific Rim gets nasty. Confucious sneezes, Matt runs.
Investors with a yen for risk (pun intended) may well revisit the enchanted land of carnival, samba, caipirinha, lambada, kayoma and Gisele that I fell in love with the moment I first stepped foot in Rio de Janeiro. Brazilian sovereign debt offers a risk/reward calculus that is far superior to anything I can find in MENA or South Asia. Why? The central bank in Brasilia has tightened its policy selic rate seven fold to 13.75% since March 2021 even as the Fed and the ECB limp way behind the inflation curve.
If Brent crude falls below 70 as the global economy/China tanks, Mexico could also prove to be a compelling idea as long as the Banco de México keeps its policy rates above 9% and thus anchors the Mexican peso, the most liquid FX cross in EM. Mexican policy rates have doubled and sovereign credit spreads have widened across the EM constellation in East Europe, Asia and Latin America. I would only invest in bonds from Brazil/Mexico since sovereign debt restructuring risks are way too high for junk credits below BBB.
While EM spreads have bloated to five-year highs, all is not hunky dory in the planet’s banana republics and misgoverned autocracies who will be in the IMF’s intensive care unit this winter. Get real, get out!
