The emerging markets irony

It is one of life’s ironies that the asset class that has been particularly badly affected in the past two months has been emerging markets, which had been flying high earlier in the year. It is also ironic as they have better fundamentals, being more solvent and with stronger growth potential than their European counterparts.

This weakness has not been confined to emerging equities. EM debt spreads have widened, with the JPMorgan EMBI+ spreads widening from 300bp over Treasuries at the end of July to 450bp currently – the widest levels since mid-2009. Interestingly, the CDS market is starting to price in increasing risk across the universe, with spreads widening for Brazil, China and Russia (see COTW). There have been concerns about the deterioration in China’s property markets, with some developers reportedly in real distress. This is unsurprising given the extent of the monetary boom and now bust (we have consistently cited the risk of a hard landing for China), but with USD 3.2 trillion in FX reserves, fears of a sizeable deterioration in China’s credit quality look overplayed. Nevertheless, the lesson to take from this price action is that the “decoupling” arguments should be treated with a healthy dose of scepticism, and any move into global recession would be damaging for the asset classes. Nevertheless, we remain constructive on emerging markets (both debt and equity), as we still believe that the cycle could turn up again around year end.

The chart shows estimated default probabilities estimated from five-year credit default swap spreads in Brazil, China and Russia. While all three economic powers remain in good shape, it is notable that the recent market volatility has taken its toll on emerging markets. Unless there is something fundamental that the investment community has missed, this move looks overdone