Tuesday, July 29, 2014

Emerging market yields and secular stagnation

FT points to an apparent "breakdown in correlation between risk and reward" on emerging market (EM) bond yields. As the graphic below shows, the premium (as reflected in the spread over US Treasury Bonds) required to invest in EM bonds, which was inversely related to EM GDP growth rates before the sub-prime meltdown, has stayed low despite declining growth in these economies.
So, what gives? The conventional explanation, as outlined in the FT article, attributes this to a "search for yields" in an environment where developed markets suffer from ultra-low interest rates, excessive credit supply from quantitative easing, and economic weakness. All of this has made EM's with their relatively higher interest rates and better economic prospects more attractive. The flip side with this being that once the developed economies recover and interest rates rise, the reversal of capital flows will drain EM bonds and restore business as usual with EM bond yields. 

However compelling this argument, certain deeper structural factors may also be at play here. In particular, the secular stagnation hypothesis, being advocated by economists like Larry Summers, may have an echo in the EM bond trends. As Summers explained in a recent interview, secular stagnation refers to the inability in developed economies for "investment to absorb all savings". The attendant consequence is one of a lower trend financially sustainable (in the absence of any bubbles) growth rate for these economies and possibly a lower trend interest rate. 

If this were true, and there are several compelling arguments in favor, then there is a strong likelihood that the EM bond trends go beyond a mere "search for yields" to a "search for investment opportunities". This would in turn seek to permanently narrow down the spreads between EM bond yields and US Treasuries. In that case, the long positions on EM bonds may not turn out as bad as is being portrayed by conventional wisdom today. 

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