Article / 01 November 2017 at 11:30 GMT

Weekly Bond Update: EM on the brink, asset allocation key

Manager, Global Sales Trading / Saxo Bank
Denmark

  • EM challenged by strong dollar, lower commodities, high valuations
  • US no longer a safe-haven as Trump pulls out of globalisation consensus
  • Investors seeking an alternative to volatile equities should consider bonds

By Althea Spinozzi

Brazil, Russia, India, and China – the 'BRICs' – have been the mantra over the past 15 years. The term 'BRIC' was coined by former Goldman Sachs asset management chair Jim O’Neil in 2001 and since then these countries have seen exponential growth even though they were affected by episodes of volatility.  

Emerging markets in general have been benefiting from tighter central bank policies over the past few years and have broadly exceeded expectations. Of late, however, investors have grown increasingly bearish as EM fund inflows slow down.

The reality is that EM are challenged by three specific factors: a strong US dollar, low commodity prices, and high valuations.

Moscow

 Russia was particularly hard hit by the fall in oil prices since 2014. Photo: Shutterstock


Even though the US dollar has lost 11% against the euro since the beginning of the year, the dollar continues to be well above its 2014 levels and despite political uncertainties in Washington, the US economy is increasingly robust, pointing to the fact that the USD is not likely to return to its 2013-2014 levels.  

A strong US dollar combined with increasingly hawkish policy and interest rate hikes from developed market central banks might prove deadly for many EM companies and governments that have taken advantage of favourable market conditions in order to finance their ongoing operations in USD.

Commodity prices are proving to be a trap as well. As a matter of fact, many emerging countries are heavily dependent on commodity exports and even though it looks as if commodity prices are going to marginally recover in 2018, prices will still be below the levels seen at the beginning of 2014.

Lastly, higher asset valuations in both the bond and stock markets has pushed many investors to look beyond their comfort zones to find higher-yielding opportunities in emerging countries. This flow has further swelled the value of these assets, making the overall space “expensive”. 

An expensive space

In order to understand how EM grew so expensive, one can look at the the USD-denominated government bond issued by China last week where Beijing was able to place five- and 10-year government bonds at +15bps and +25bps over the Treasuries. 

Adding to the above, EM political uncertainty might pose a still-bigger risk as we have seen in South Africa over the past few weeks; economic conditions are weak, and the political crisis is digging the country's economy even deeper. Consequently, yields rose last week and they will continue to be volatile as the African National Congress approaches and there is no clarity on the results.

In Russia, the financial sector is finally showing some weakness with Bank Otkritie looking for grounds to write off bonds due in April 2019. At the same time, Russian Standard Bank has commented that the bonds of Russian Standard Ltd. are not linked to the bank, making investors fear a possible default.

Investors are learning that the risks are as high abroad as they are at home. Even though the West has been able to limit losses following the 2008 crisis, and now is in the process of normalisation, today's “normal” will be different than it was pre-2008.

De-Americanisation

Trump’s presidency has finally put an end to the post-World War II circumstance we knew as “Americanisation”. For over 70 years, the US has led international talks and formed the global consensus. Now, however as the world continues to move towards more comprehensive globalisation, the Trump administration is stepping away from international agreements and aiming to close beneficial bilateral arrangements. 

Trump’s administration also increases political uncertainty, making the US dollar and US Treasuries more volatile and sensitive to political and economic developments. The dollar and US Treasuries have long been regarded as safe havens but the reality is that these may be the first assets to become decidedly unsafe as rash decisions continue to issue from the Oval Office.

One good example could be how Trump is reportedly set to deal with the Puerto Rican hurricane crisis by wiping out Puerto Rico’s debt. Money cannot be safe in a country where the president doesn’t understand the profound consequences of wiping out government bonds. 

The US is no longer a safe haven.

This puts many investors in awkward position. We may well be approaching a crisis in EM, but money is no longer safe at "home" either!

Stocks at the heights

One of the biggest trades in 2017 has been shorting the S&P 500 as investors thought that the index had reached its top and would soon go down. This trade has revealed to be costly as the index is up 15% since the beginning of the year.

If equity traders believe stock markets will be more volatile in 2018 as current levels struggle to find support, they should look at the bond market. The beauty of fixed income is that when you buy a bond you essentially lock in a specific yield... unless the company is unable to repay the notional, of course. 

Equities

 Many investors are growing weary of unpredictable and volatile equity markets.

Photo: Shutterstock

This means that if you like a particular company but believe that the stock price will be volatile due to external factors, you can guarantee an annual return without being affected by market volatility (provided you are confident that the company is sound and will be able to repay back its debt).

We have looked at the most heavily traded stocks in the Saxo platform this year in order to find out which bonds may be interesting for equities traders. A few names got our attention...

  • Tencent Holdings Limited. The company provides internet and mobile value-added services (online advertising and e-commerce transactions globally). Tencent stock soared 84.5% this year. In case investors believe the party will be over in 2018, the company has several US dollar bonds with maturities between 2018 and 2025. Tencent 3.375% May 2019 offers approximately 2% yield.
  • Santos Ltd. It's a different story for the Australian explorer and producer of natural gas where prices this year were a little bit like a yo-yo, reaching bottom in July and recovering in the past couple of months. In case you like the company but you don’t wish to be exposed to the stock’s volatility, the company has a US dollar bond paying 4.125% coupon with 2027 maturity, this indicatively represents  a4% yield.

The music is obviously over and an EM crisis can spread quite easily to developed markets. Sooner or later, the equities market will show signs of weakness.

Thus, asset diversification is always the key.

— Edited by Michael McKenna

Althea Spinozzi is a sales trader at Saxo Bank

01 November
Daniel CN Daniel CN
Why is the music obviously over? Where do you see that?
01 November
Market Predator Market Predator
Hello Althea, could you please explain: wiping out debt of Puerto Rico issue after hurricane?
BTW: This is true wisdom for me: "The beauty of fixed income is that when you buy a bond you essentially lock in a specific yield... unless the company is unable to repay the notional, of course."
Finally just for fun, this is most awesome scene from Margin Call (2011) regarding "Music is about to stop" Enjoy it :) https://www.youtube.com/watch?v=Hhy7JUinlu0
01 November
Althea Spinozzi Althea Spinozzi
@MarketPredator. I mentioned Puerto Rico and Trump’s idea to wipe out the government debt in order to stress the fact that the president of the US is unpredictable, which makes the US market risky. Eheheh I remember that scene in “Margin Call”, nice movie!

@DanielCN. There are signs of weaknesses in the EM especially in South Africa and in Russia. On the top of it, the USD continues to be strong, commodity prices are low, stocks and bonds are too expensive. It is just a matter of time.
01 November
Market Predator Market Predator
OK and do you or any Saxo research see possible replacement for US10Y, in case it will be no more safe heaven proxy? Of course this is question relevant in far horizont.
02 November
Althea Spinozzi Althea Spinozzi
Hi Market Predator, I have been thinking at the safe heaven topic and I am more and more convinced that bonds of blue chip companies are the ones that would better serve this purpose. Uncertainty is growing higher in government bonds amid the Brexit, Catalan Crisis and Trump, thus I believe that solid corporate names offer sounder opportunities.
02 November
Market Predator Market Predator
Thanks
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