More on the move to safe havens and contagion in high yield

Today’s Commentary

A few weeks ago, I wrote about the slowing of Chinese growth and the rout in commodity currencies, something that affected both developed markets and emerging markets that were leveraged to Chinese growth. But over the past few weeks, the concern has become emerging markets. The Fed’s tapering is only a proximate trigger. Much of the selloff has to do with political issues and macro imbalances in specific markets, just as the European sovereign debt crisis was about specific macro vulnerabilities after the Dubai World trigger. The question now goes to contagion from private portfolio shifts. The move to safe havens may have begun. And now evidence is amassing that investors are shifting away from all riskier assets, not just emerging markets.

In my weekly markets theme piece on Friday, I pointed to the differential treatment Turkey and India were receiving as evidence that there was some discrimination on country risk amongst investors. India was hit hard during the taper tantrum in the spring and fall, but has not suffered as much this time because it seems to be dealing with governance issues. On the other hand, Turkey’s governance issues are still worrying. And so Turkish assets have sold off.

The question in crises is contagion because contagion is what makes a crisis a crisis. The problem is indiscriminate selling and a wholesale shift into safe havens as risk reduction sentiment overwhelms all other considerations. That’s what crises are all about. And we are not there yet. Some see the selloff as a buying opportunity. However, the signs are mounting that stress is building. Last week I wrote about the move to safe havens into the US dollar, and specifically US treasuries, into the euro, and into precious metals. But since that time, other signs of portfolio shifts have developed.

For example, Bloomberg reports on the outflows of money from high yield, an area that has been doing well.

Late last week, Lipper, the mutual fund performance analysis service, said investors had pulled another $972m from the funds and ETFs betting on junk bonds in the week ending February 5, bringing total withdrawals so far this year to $1.4bn. Investors instead favoured funds investing in corporate bonds with higher credit quality and US Treasury securities.

The reversal in sentiment for US junk debt comes as the Federal Reserve reiterated last week the plan to slow down its bond-purchase programme at a clip of $10bn each month.

Without the Fed’s massive monetary stimulus and with the short-term outlook for US stocks less clear, investors are no longer being properly compensated for holding some of these weak-credit quality bonds, analysts said.

“For the last couple of years the Fed has been indirectly supporting the high-yield market by pushing yields on everything else lower,” said Adrian Miller, director for fixed-income strategy at GMP Securities.

“That’s no longer the case. Without the Fed, if the stock market falters, high-yield bonds may start to suffer.”

Note that the narrative of the article is not necessarily the actual narrative developing. However, the concept that a shift out of high yield is partially driven by the Fed’s tapering is something to watch because defaults in high yield have been low, sentiment has been positive and spreads have been narrowing. An outflow of funds will automatically mean that high yield bonds will be sold to deal with redemptions. And that will increase yields.

Then, in China, where unlike in the US, bad debt is building and defaults are rising, high yield is suffering too:

The extra cost to borrow for China’s riskiest companies is at the highest in 20 months as soaring interest rates heighten concern the nation will experience its first onshore bond default.

The yield gap on five-year AA- notes over AAA debt jumped 27 basis points last month to 224, the most since June 2012, Chinabond indexes show. Ratings of AA- or below are equivalent to non-investment grades globally, according to Haitong Securities Co., the nation’s second-biggest brokerage. The similar spread in the U.S. is 403 basis points, Bank of America Merrill Lynch data show.

The failure of coal companies to meet payment deadlines for trust products has increased concern over debt defaults, with the equivalent of $53 billion of bonds sold by renewable energy, construction materials, metals and mining companies due in 2014. A report on Jan. 30 signaled China’s factories are contracting for the first time since August amid signs of financial stress including mounting losses and bailouts.

“China’s bond market will definitely see its first default this year,” said Xu Hanfei, a bond analyst in Shanghai at Guotai Junan Securities Co., the nation’s third-biggest brokerage. “The economy is slowing while the government seems still confident about growth, which means the authorities probably won’t announce any measures to avert the slowdown. This is the worst scenario.”

Again, the narrative of the article is not necessarily what is actually developing but it is a compelling narrative given the fact that Chinese growth is indeed slowing and bad debts are rising. The Chinese government has worked against this in two ways. First, they have supported credit markets by injecting liquidity whenever there has been a panic rise in yields. Second, the Chinese have allowed the evergreening of loans in order to let the bad debt problem roll off over a period of time rather than mushrooming all at once. So far these tactics have worked in slowing the Chinese economy slowly. However, the fear should be the process spirals out of control and the markets become too dislocated for this intervention to succeed any further. The Chinese growth slowdown is the major cause of the emerging markets crisis in my view. Therefore, anything that adds to Chinese slowing is bearish for emerging markets and has the potential to produce contagion which causes a full blown crisis.

The impact on debt issuance and equities markets is clear. Russia recently cancelled a domestic bond issue because of EM volatility. EM debt-linked notes issuance is down 89%. Outflows from EM equities are greater this year in one month than in all of  2013.

In terms of the real economy, emerging markets output slowed to a 4-month low in January. China is the biggest concern here but we saw slowing growth in Russia, Brazil, Turkey and Indonesia as well. Winners were India, Taiwan, Mexico, Poland and the Czech Republic. I think the real economy data highlight why India is not in the hot seat and countries like Turkey are and Brazil soon will be.

My biggest concern is Brazil because of the combustible mix of a large economy, poor governance, social fraying, rising inflation, rising interest rates, a slowing economy and a declining currency. I believe adding Brazil to China as a cause of emerging markets stress would be catastropic for sentiment and cause serious contagion. Thus, Brazil is the country I am watching right now.

Even if we can successfully get through this crisis without it becoming another global crisis, the damage will be significant in terms of policy. If you’re an emerging market country getting lit up right now, what’s the lesson? Listen to Stephen Roach talking on Bloomberg last week. At 4:38 into the clip, he talks about what is happening in EM, saying, “they ran big current account deficits, at least in most of them, except China. And now they’re paying a price for that.” The lesson of this crisis then is “run a current account surplus and accumulate reserves”. None of the mercantilist reserve accumulators are in the hot seat in emerging markets right now. The others will join them with current account surpluses and accumulate reserves if they can.

How can everyone have a current account surplus at the same time? Emerging markets want it. The eurozone wants it. And even the US wants to increase its exports. Everyone is talking about expanding internationally when the problem is high debt levels constraining domestic consumption. This is beggar thy neighbour pure and simple. And it will lead to more volleys in the currency wars as nations try to manipulate their exchange rates to improve their external balances. The result will be pressure on wages, job growth and economic nationalism as an outgrowth of the poor wage and job growth.

The emerging markets crisis has settled down somewhat. But, unfortunately contagion is rising. The crisis has a long way to go before it is over. We are just beginning.