HY Has Momentum. Be Wary of the EM Tranche.

It is clear that the North American High Yield index tranche is making a big move and looks to be gearing up for spread improvement. No such move in its cousin, the EM tranche. If you are looking for momentum, long HY looks like the winner for a while.

Corporate EM debt typically has a HY rating, but within the borders of their respective countries, these issuers have the look and feel of investment grade. This creates some interesting tensions between the two indices. You see them crossing each other several times even in the last few months.

My initial take on the recent underperformance of EM versus HY is straightforward:

Energy: Energy plays are common in both tranches, but the effect of cheap energy inputs provides offsetting support to other constituents in the HY index. The effect on EM is not nearly so supportive.

Economy: The US economy is showing a resilient labor market and decent numbers to go along with it—so much so that people feel good enough about the future to have a good crop of babies. With China letting up on stockpiling commodities, the EM world is looking weak.

Russia: I’m not sure how big an impact Russia plays on EM anymore given the extent of the sell-off in Russian assets, but the downgrade of Russian Federation debt to junk can’t be giving a good vibe.

The matter is more complicated than this cursory view. The data is giving a different read of the matter. I am using the BRIC 40 “titans” equity index as a more liquid proxy for EM credit—this is indeed imperfect. It shows that financials and IT carry a bigger weight than energy. In fact, the share of energy is about that same in HY and EM and 17% and 16%, respectively. BRIC equity performance has held up relative to oil well.

What you see below is this same BRICs titans equity compared to a model that incorporates moves in Brent Crude and an index of broad energy debt. Three years’ worth of data tells me that BRIC equity isn’t well explained by moves in either. It is likely that this proxy for the far more illiquid EM CDS index will have no better fit.

The observed trend may be quite persistent and thus investible. The Russian problems weigh on EM overall not because of the energy sector specifically, but because the problems within the Russian energy sector reflect broader concerns across EM debt. The effect of Russia is more opaque, more subtle, and more stubbornly difficult to resolve.

Sanctions have revived a long-standing concern that is broader than the evolution of energy patterns. A major reason why Russia is crippled under the current sanctions is because of problems related to mismanagement and corruption within the overall economy. Traditionally it overcame this intrinsic efficiency by devoting large amounts of resources to areas considered critical. Devoting such resources by command and control makes corruption inescapable.

There is growing concern that Russian isn’t alone in these problems. Brazil is faces the same endemic corruption problems as Russia, though it shows greater ability to address and resolve the problem. China is preparing for a bursting credit bubble the likes of which no one has ever seen. India is golden and immune, benefitting from cheap energy like nobody else.

Russia, Europe’s unfriendly neighborhood gas station, has been this way since I’ve been alive, likely since the Mongols came across the steppe, broke them down, and twisted their self-image. They spend their capital on brute force methods of energy extraction because they don’t have the technological capability to extrtact energy any other way. Energy is the preserve of the Russian kleptocrat, and loading up on armaments is his means of expression.

This is a harsh but accurate assessment of Russia. It is a country that needs radical and dramatic change in laws and leadership if it going to successfully improve living standards for the common Ivan. Thankfully, the rest of the emerging world is in far better shape, but the specter of Russian incompetence will hang over the space for a while yet.

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