Wednesday, June 4th, 2014

Melt-Up

Two months ago, as the Ukrainian crisis was starting, we wrote our first piece on emerging market bonds (It’s An Ill Wind, 18 March 2104). We argued that if investors wanted to buy something which would be resilient in the face of a geo-political crisis they should look at EM sovereign bonds (hard currency). We argued that they had already suffered from an equivalent crisis (the balance of payments crisis in Summer 2013) and would not be additionally affected by another one, whereas developed markets would. We noted that volatility was trending down, that returns were recovering, and said, “Once a bond market has begun to be rehabilitated, the process can last a long time and be resilient in the face of poor newsflow. The peripheral countries of the Eurozone are a good example of how this works.”

There is an interesting parallel between the Eurozone in 2013 and Emerging Markets now. In June 2013, our Eurozone bond model had Spain, Italy and Ireland as its three biggest Overweights, but Portugal and Greece were still Underweights, because of contagion fears. By late July this had changed. All the periphery countries were rated Overweight and all the core countries (Germany, Austria, Netherlands etc) were rated Underweight. Nothing fundamental happened during that period – news of Portugal’s escape from the EU bail-out or Greece’s return to international bond markets did not come until this year, but there had been a gradual reduction in volatility and a recovery in returns as investors re-evaluated the prospects of these countries.

Where the bond markets led, equities followed. Over the next three months, we noticed a near doubling in the weight of Eurozone equities in our US asset allocation model. From 18% of the portfolio at the end of July, they rose to 34% by the end of October. The scale and durability of the rally in both asset classes took many investors by surprise, but what we would highlight is the extent to which they were interconnected. Peripheral bonds did well, as did Financials and other bond proxies in the equity market (e.g. Utilities and Telecom). These sectors are over-represented in the periphery, which meant that the local equity indices outperformed Pan-Europe, which allowed the peripheral bond market to carry on rallying.

Contagion can work in reverse, vicious cycles turn virtuous, melt-downs give way to melt-ups. We think that a similar pattern may evolve in emerging markets. The time-lag between the turn in bond and equity markets in the Eurozone was three months; it is two and half months since we first noticed the rally in EM bonds. There is of course the risk that there is a correction on global equity markets over the summer. Our models suggest that investors are exposed to that risk if they have an Overweight in equities, so they might as well own something which will actually go up if there isn’t a correction. EM equities currently account for 7% of our portfolio.

The other side of the trade depends slightly on where the investor is based, but our US model has recently downgraded Eurozone equities from Overweight to Neutral and we have begun to reduce exposure to the periphery in our Eurozone bond models.

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