(Part I) EM Credit Spreads: Unsustainable Divergence

EM sovereign and corporate credit markets have so far defied the selloff in EM equities and foreign exchange markets, but the odds of material spread widening are considerable.


As G7 central banks have crowded out global fixed-income investors from G7 bond markets by depressing yields, investors have rotated into other segments of global fixed-income markets and bid up prices of hard-currency denominated EM sovereign and corporate bonds. Our EM strategists believe the stampede into EM credit markets has gone too far, and that these divergences between EM currencies and stocks on the one hand and EM credit markets on the other will not be sustainable.

Today, EM countries’ private sector foreign debt levels (as a share of GDP) are not lower than at the end of 1996 and early 1997, when the emerging Asian crisis commenced. This is not to argue that the EM world is headed for a similar crisis like what transpired in 1997-’98. The point is that currency depreciation raises foreign debt burdens and as such should lead to a re-pricing of credit risk – i.e., wider corporate spreads.

Although the EM public sectors’ foreign debt burden is very low, most developing nations’ fiscal positions will deteriorate going forward. This will occur because the growth slowdown will drive down corporate profits and consequently governments’ tax intake. In the meantime, political pressure to keep the population happy will lead many EM governments to loosen the fiscal purse. All in all, government debt and budget deficit dynamics will worsen, justifying higher spreads on sovereign credit.

Weaker EM growth and commodity prices also represent a menace to EM credit markets. Please see the next Insight, (Part II) EM Credit Spreads: Unsustainable Divergence.

Are Investors Finally Warming Up To Chinese Stocks Again?

Chinese equity markets reacted favorable to improving PMI reports from China – a sign that investors are finally hopeful a sustained recovery is underway?

Chinese Stocks

The HSBC/Markit services purchasing managers’ index posted its strongest reading in seventeen months. Granted, the service sector has not been the major source of weakness for the Chinese economy. Nonetheless, investors liked it.

Indeed, the Chinese stock market has been showing signs of regained vigor of late, with both domestic and investable stocks breaking above key technical resistant levels that have been in place for years.

Chinese stocks, especially the domestic market, are notoriously volatile, driven by momentum chasing retail investors. But it is good news that the momentum is finally in a positive direction.

Overall, our China team continues to believe the risk-return profile of Chinese stocks is now positive due to a combination of depressed valuations and a strengthening growth and profit outlook.

U.S. Financials/Consumer Staples: Stick With It

Our U.S equity team continues to recommend a long financials/short consumer staples equity pair trade.

SP Financials

There are high odds of further gains in coming months as business confidence picks up, and hiring and capital spending gain traction leading to a narrowing output gap.

Importantly, the relative share price ratio has been positively correlated with the output and unemployment gaps. Financials profits benefit from reviving animal spirits, rising loan activity and increased capital formation. In contrast, consumer staples demand underwhelms at the margin as the economic recovery gains enough thrust to become self-sustaining. This message is corroborated by our relative sale-per-share models that are pointing to a brighter demand backdrop for the financials sector compared with consumer staples businesses.

In the absence of a relapse into a deflationary environment, financials will maintain the upper hand over consumer staples.

U.S. Q2 GDP: Good (If It’s True)

At 4%, U.S. real GDP made an impressive comeback in the second quarter relative to Q1. Of course, just like previous readings, this data is subject to revision.


To the extent that data covering the past quarter matters for markets, investors should note that today’s GDP release is a preliminary estimate, subject to two revisions over the next several weeks. The Q2 data was healthy and shows that the economy has decent momentum going into the second half of the year.

However, there were revisions to the GDP data for the past three years that show that U.S. growth was even weaker than previously reported in 2011 and 2012. The average growth rate from 2011 to 2013 was revised down from 2.2% to 2%.

Despite our reservations about the GDP data, we are not surprised by the 4% Q2 print. As mentioned in previous Insights, there is plenty of evidence that the U.S. economy is gaining momentum. Survey data of the manufacturing sector, the budding strength of the jobs market and the lack of headwinds compared to previous years of the recovery all suggest that a period of above trend growth should persist.

Importantly, the Q2 GDP data will no doubt be scrutinized at the FOMC meeting today. If anything, the Fed may conclude that the output gap is slightly larger based on the downward revisions to GDP in previous years. The offset to this is that more recent data suggests the current momentum is somewhat stronger than previously believed and could surprise further to the upside. On balance, we doubt that today’s data will trigger a change in the Fed’s dovish rhetoric. Nonetheless, improving data, especially on the consumer side, does serve as a warning that the long era of ultra accommodative monetary policy is nearing an end.

Will USD/JPY Finally Break?

USD/JPY has been frustratingly stable but our bias is to expect it to break lower:


  • The BoJ kept policy on hold last week and gave no indication that it is about to increase its asset purchases.
  • Valuations are stretched. Our PPP model says that USD/JPY is overvalued by more than 20%
  • Positioning and sentiment indicators show excessive pessimism towards the yen. Long Nikkei/short yen trades have made no money for investors over the past year. Investors may be losing patience with this trade and may cut their positions at the first signs of trouble. This could cause a cascading effect as stop-losses get triggered, leading to further selling.

Bottom Line: Fundamentals and technicals point to a downside break in USD/JPY. Also, as last week’s events in Ukraine/Russia highlight, global risk aversion can spike without warning. Shorting USD/JPY serves as a valuable hedge to portfolios.