There are some signs of trouble in emerging markets. And the money at risk now is bigger than ever.
The yield spread between high grade emerging markets and US AAA-rated corporate debt has jumped, almost doubling in less than three weeks to the highest level since mid-2012.
MSCI Emerging Markets Index and Yield Spread between High Grade Emerging Markets and US AAA Corporates: 14 March 2003 - Today
Source: US Federal Reserve.
This means that the best credit names in emerging markets have to pay a bigger premium over their US counterparts to get funding. When this spread spikes up and continues above its 200-day moving average for a sustained period of time, it is typically a bad sign for equity valuations in emerging markets, as shown in the graph above. One swallow does not a summer make, but it is worthwhile keeping an eye on this indicator.
As yields go up the value of these emerging market bonds goes down, resulting in losses for the investors holding them. The surge of the US dollar in recent months could magnify these losses: if the bonds are denominated in local currency they will be worth a lot less to US investors; otherwise, the borrowers will now have to work a lot harder to repay those US dollar debts, increasing their credit risk.
Any losses could end up being very significant this time around, as demand for emerging markets bonds has literally exploded in recent years.
Average Annual Gross Debt Issuance ($ billions, percent): 2000 – Today
Source: Dealogic, US Treasury.
Note: Data include private placements and publicly-issued bonds. 2014 data are through August 2014 and annualized.
As the graph above shows, the issuance of emerging market corporate debt has risen sharply since the depths of the 2008-09 financial crisis. These volumes are very large indeed, and now account for non-trivial portions of investors’ and pension funds’ portfolios worldwide.
Median Corporate Gross Leverage in Emerging Markets (GDP-weighted, ratio): 2007 – Today
Source: Bloomberg L.P., Morgan Stanley, US Treasury.
Note: Gross leverage is the ratio of total debt to EBITDA. Corporate leverage is averaged from the trailing four quarters and is based on firms in countries including: Brazil, China, India, Indonesia, Poland, Russia, South Africa, South Korea and Turkey.
As a result, emerging markets corporations are now leveraged to the hilt, easily exceeding the 2008 highs by almost a multiple to EBITDA. And why not? With foreign investors desperate for yield as a result of all the stimulus and money printing by their central banks, they were only too happy to oblige.
And they were not alone. Governments in these countries were also busy doing some borrowing of their own, as their domestic capital markets deepened.
Foreign Ownership of Emerging Market Local Currency Government Bonds (%of outstanding)
Source: International Monetary Fund, US Treasury.
This graph shows that foreign investors have also piled into locally denominated bonds of emerging markets governments. Countries like Peru and Latvia now have over 50% foreign ownership of their bonds. We could not find comparable data sources going back further in time, but we would venture to say that this level of foreign ownership in local currency is unprecedented in emerging markets.
So what now?
Emerging economies certainly have a lot going for them: an aspiring middle class, positive infrastructure multipliers, favorable demographics and so forth. But there are big speculative reasons behind the recent money flows going into these countries – which could reverse very quickly should the tide turn.
Concerns about the value of the US dollar pursuant to the unprecedented money printing by the Federal Reserve prompted many investors to diversify their currency exposure in the post-crisis period; the recent dollar strength is probably giving them some concern, if not regret. Then the commodity complex has been battered, depriving many of these economies from an important source of capital and foreign exchange. The high leverage further amplifies any financial risks. And the ripple effects from the ongoing spat with Russia can’t be helping either.
Therefore, the tide could turn indeed. What is often forgotten in the rush for yield in faraway lands is that the process of economic convergence takes a long time – with many hiccups along the way. If investors end up rushing for the emerging markets exit for whatever reason, with this unprecedented level of exposure they might be bringing home much more than a bruised ego and an empty wallet.
For one, European banks are hugely exposed to emerging markets. Any impairment to their books would likely make any new lending even more difficult, at a time when there is already a dearth of non-government credit in Europe. And if emerging economies falter, where will the growth needed to repair Western government and private balance sheets come from?
It used to be said that when the US economy sneezes the rest of the world catches a cold. Now it seems all we need is a hiccup in emerging markets.