Leaders are becoming laggards

The emerging markets have made the headlines this year with the connotations becoming more and more negative as the year progressed. There were various reasons for this, but the prevalent themes have been the weakness in the commodities market and the repercussions of a monetary policy tightening in the US.

Starting with the latter, as early as last year, analysts started cautioning that the strengthening of the US economy is due to gradually close the growth gap between the emerging markets (EM) and the US. This in turn means that investing in such economies becomes relatively less appealing which should translate in slower inflows or even outflows. Such fears were further augmented by country-specific challenges such as political risks and structural burdens in Russia and stagflation prospects in Brazil.

Another implication of a more “bullish” Fed is a stronger USD which in turn increases the cost of USD denominated debt issued by emerging market names. This has become a notable concern after several years of money printing has supported the search for yield and nudged investors to take on more risk. Indeed, over the last few years the bond markets have become increasingly accustomed with EM issuers, and their foreign currency debt stock has grown. Having said this, one has to take into account that some of these names are exporters which could see their EBITDA increasing due to a weaker currency (stronger USD).

The commodity related names were also generally considered to have a natural hedge against FX fluctuations because the prices for their output are set in USD on the international markets. However, with many commodities trading lower this year and some in a multi-year bear market, this does little to alleviate worries. Indeed, many commodity issuers have experienced an increase in leverage as EBITDA declined on the back of lower prices and slowly increasing volumes.

Against this backdrop, emerging markets bonds have underperformed their similarly rated peers over the last few months with China triggering renewed uneasiness more recently. Indeed, at this stage, the developing economies are perceived as being more vulnerable to a slowdown in Asia’s largest economy.

These dynamics are likely to lead to further downgrades and possibly further increase the representation of emerging markets in the high yield indices, particularly the USD indices, after similar developments earlier this year. Taking the Bank of America Merrill Lynch USD Global High Yield Index, the share of the BRICs corporates already increased from 10% in March 2015 to 12% in June 2015 notwithstanding the decline in prices. Accordingly, investors playing the USD high yield market through funds should, in my opinion, closely scrutinize their mandates and benchmarks as those with greater flexibility and ability to focus on US domestic names are likely to outperform over the next few months. To put it differently, I am of the opinion that in the current environment, one needs to increasingly differentiate between USD and US high yield bonds.

Have a nice day!

Raluca