Two Emerging Market Shelters in the Storm

Summary

I posted about two places to huddle up given the Big Kahuna deterioration in emerging markets. They are both in credit-land.

  1. The awesome carry power of Brazilian linkers. Market-value-weighted yield to maturity stands at 17.5%. The logic is simple and historically tested: Brazil tends to print their way out of their problems. This time will be no different and linkers are the best play in an economy with no growth but the capacity to print enough to avert default. The trick is that patience. This means no leverage in such a thin market as it will force you out. You are getting paid to wait.

  2. Korean bank debt. This is an economy that is an emerging market in name only. It has not only advanced tech and a diversified economy, it also has a large enough tradables sector that its government securities can generate a flight to safety bid. Given the balance sheet capacity to shore up its banking sector, bank debt offers a yield spread over Korean govvies with the price appreciation that comes with them.

Takeaways:

There are two reasons why global financial markets are selling off. One is that the Fed has signalled the global economy sucks. the second is that the Fed will have to disrupt money market functions to make a rate hike mean translate into money markets, much less credit markets.

Take pain in exchange for Brazilian carry that now exceeds 17% in LCD terms.

Expect continued capital appreciation in Korean bank debt as a result of continued bull flattening in the sovereign curve.

*

Unless you live under a rock, you know that emerging markets are a pain trade. Most knew this was coming, but for the wrong reasons. The consensus view was that USD-based interest rates would rise, and as a result would drive capital flight from emerging market LCD debt. The impact of the resulting dollar rally would impair serviceability of the existing debt pile as it impacted export revenues in commodities.

But there was and is a deeper dynamic at work. Any Fed rate hike will not be easy to implement. Back in the good old days of my Uncle Larry, all that was required was increasing fed funds rate. The financial system the Fed manages now is different. It is a truly planetary system, not just a system of US-domiciled banks. Fed funds plays a bit part in the global financial system. Instead, there are several short-term interest rates that matter: the Fed’s interest on excess reserves (IOER), fed funds, the Fed overnight reverse repo rate (RRP), the overnight collateralized repo rate, and the overnight AA (pretty much top tier bank) commercial paper rates. The larger players in this global system include corporate treasuries that are net creditors into money markets, willing to pick up small yet reliable returns by investing in “riskless and cash-like” investments. This includes short-term hedged credit instruments (AA commercial paper), collateralized lending (repo), and the rate of return on alternatives to money markets (IOER). It is clear that any rate hike will have to include sizable reverse repo to drain liquidity in addition to setting benchmark rates. Otherwise, the system can merely absorb the changed time value of money reflected in Fed funds and IOER and leave wider rates unchanged.

This scares rates and credit. The idea of a Federal Reserve essentially out of control unless it reverses the broader flows seen in repo and excess reserves implies things getting out of control. For more on this, see this.

But the Fed didn’t raise rates. And yet broadly speaking, markets continue to sell off.

Markets interpret Fed hesitancy to initiate higher rates as indicating two things: the Fed cannot easily extricate itself from accommodation without causing significant dislocation. So markets are pricing in dislocation.

Also, continued easing indicates that the global economy is heading for recession. Given the growing influence of emerging markets in the global economy, assets should be priced as such. This creates a feedback loop where anticipated decline in Chinese demand for commodities leads to an ever higher DXY level, which further impairs export revenue and credit worthiness of countries like Brazil and Russia. Enter the downgrades.

I have posted about two places in credit land to hide given the deterioration in emerging markets:

  1. The awesome carry power of Brazilian linkers. Market-value-weighted yield to maturity stands at 17.5%. The logic is simple and historically tested: Brazil tends to print their way out of their problems. This time will be no different and linkers are the best play in an economy with no growth but the capacity to print enough to avert default. The trick is that patience. This means no leverage in such a thin market as it will force you out. You are getting paid to wait.

  2. Korean bank debt. This is an economy that is an emerging market in name only. It has not only advanced tech and a diversified economy, it also has a large enough tradables sector that its government securities can generate a flight to safety bid. Given the balance sheet capacity to shore up its banking sector, bank debt offers a yield spread over Korean govvies with the price appreciation that comes with them.

I see the case for buying Korean bank equity and holding on for a few years. But you are going to get killed for a while. Korean bank common stock is a position traders paradise, because the Korean banking system isn’t going BK. However, Korean government debt is headed for a bull flattener (see the 2s10s). I think Korean bank debt is gong the same way. There’ll be a time for moving down the capital structure, but this isn’t it.


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