China’s surprise yuan devaluation was by far the major headline last week, with the government deciding to counter the currency’s recent appreciation due to the close relationship with the strong US dollar. The news unnerved markets worldwide as investors felt the move was taken in order to mask even slower growth than expected, but sentiment recovered as the week went on; among US indexes, the Dow was up a refreshing 0.6% (although still -2% YTD), while the S&P 500 and the NASDAQ were up 0.7% and 0.1% respectively. In our opinion, the yuan devaluation was a step in the right direction, as the currency essentially went from a nearly fixed peg to the dollar to more of a market-driven, albeit managed float. Our concern now revolves around the potential for currency wars among emerging nations. A cheaper currency helps exports in the short term, and China’s trading partners will likely decide to take similar measures to remain competitive. We decided, therefore, to look into emerging market debt this week, as we believe there’s some risk in the dollar-denominated corporate segment. Here’s why we think so:
The background: Corporations and governments worldwide issue debt in local or foreign currencies. In the recent years, firms in emerging regions took advantage of the low US interest rates, greater access to international bond markets, and the risk-free dollar nature to load up on dollar-denominated debt; consequently, the emerging market debt (EMD) market issued in foreign currencies has more than doubled to over $1.4 trillion in the past five years, according to Bloomberg. The issuance has proved to be a good fit, as yield-starved investors worldwide have been more than willing to sign up. Overall, the EMD sector has delivered an annualized return of 7.8% over the past 15 years – the best performer in the fixed income asset class. YTD, however, it has slipped, and as of July, was up 1.7%, below high yield, which returned 2.5%. We think this performance downturn could continue further. Essentially, in the EMD sector, credit and currency risk are the obvious fears for investors. With sustained dollar strength combined with US interest rate hikes ahead, foreign currencies are likely to cheapen further, in which case international dollar-denominated debt becomes harder to service for domestically-oriented firms. Investors have been taking note; according to the WSJ, funds that invest in emerging-market corporate bonds have seen outflows for three consecutive months, withdrawing $556 million, according to data from EPFR Global. The bottomline? Given a history of outperformance, the sector could be primed to retreat if the conditions outlined below play out for a while.
China’s yuan devaluation: First, let’s factor in China. The debt-to-GDP ratio here is over 280% – higher than any other developing nation. 44 countries count China as their largest export market, according to Fortune. These nations, therefore, are exposed to the combined forces of a Chinese economic slowdown, debt-laden corporations that may consequently trim back on spending, as well as a cheaper yuan given the devaluation. To counter this, if the exporting nations engage in currency depreciation tactics as well, the dollar-denominated debt, as mentioned above, faces a similar headwind, as the risk of insolvency increases due to it being harder for corporations to pay down the debt or interest.
US rate hikes: With a strengthening job scene, labor market tightening and indications of inflation, the US looks on track to raise rates sooner than later. The combined prospect of a strong US economy with a higher yielding dollar is likely to reposition investors away from emerging markets, back towards US shores. Considering the yuan’s devaluation as well, the ‘Fragile 5’ currency list has now been expanded to the ‘Troubled 10’ by Morgan Stanley, with Peru, Columbia, Brazil and others joining South Africa, Indonesia, India, and Turkey on the country list regarding currencies set to face volatility. Each of these regions have significant dollar-denominated debt exposure among local corporations, and any signs of insolvency could set off a domino effect for stock markets there – none of which a slow-growth global environment, as is, needs at the moment.
Global growth concerns: Currencies apart, the sheer ability of emerging corporations to thrive needs to be reassessed in light of a weak global economy. European growth data released on Friday for Q2 showed a meager 0.3% growth rate (below expectations), while Japanese data released this weekend showed a contraction of 0.4%. The US economy, while growing, is certainly not anywhere close to pre-recession rates, and with low inflation and pricing pressure worldwide, regions dependent on commodities including oil have suffered significantly in terms of both growth as well as currency weakness. With oil prices less than half of what they were last year, and coal, gold, sugar, and other commodities also finding themselves in bear markets, each of these factors impact the ability of commodity-driven corporations to service their debt. Per the WSJ, JP Morgan is expecting the default rate among emerging-market high-yield corporate issuers to increase to 5.4% this year, up from 3.2% last year. Consider, meanwhile, that corporate high yield bonds and emerging market debt tends to move in sync, with a correlation of .87 (per JP Morgan). KKR’s Samson bankruptcy last week was an indicator that few firms are immune to macro conditions and commodity prices, and similar results could be in store for firms abroad. Looking deeper into the energy component of the high yield class, Gluskin Sheff’s David Rosenberg highlighted in Barron’s that that the average yield there has jumped over 1.2% since May – a move comparable to a 9% correction in stocks. The bottomline? Currency depreciation, slow global growth and commodity headwinds together could cause significant chaos in emerging market debt; yields here could serve as an early indication of where stocks may be headed in the regions in the coming months.
What it means for you: With global markets treading water at this stage, economic indicators continue to point to a US rate lift later this year. While stocks will continue to get the media limelight, it’s critical to watch across asset classes – especially, in our opinion, emerging market debt. If sovereign and corporate spreads here start to widen, it may be time to position accordingly and stay defensive in the short term against a perfect storm of rising US rates, low commodity prices, and slow global demand. Next week, we’ll be revisiting earnings reports to outline some consumer-driven stocks that we think could be more immune to the conditions above. The bottomline? Staying up to speed with capital markets worldwide remains critical as Wall Street gears up for the week ahead.
