"Never let a good crisis go to waste." - Winston Churchill
Happy 4th of July weekend and thank you for taking the time to read this! If you would rather listen to the weekly add-on in podcast format, be sure to check out Macro Corner Episode #4. For Episode #5, we have another chart booklet that you can access here: Macro Corner Chart Booklet, Episode 5
Last week and the week before, we talked about emerging markets and how a plethora of issues are facing a developing world that will increasingly be prone to 3rd parties stepping in and 'solving' issues. Remembering what happened during the Arab Spring, it was food shortages causing civil unrest and ultimately revolutionary movements. In a more fractured world, that implies less certainty when it comes to the supply of commodities as a reaction function to political instability.
In addition to domestic instability in EM nations, servicing debt in foreign currency is increasingly a challenge for debtors. Paying principal or interest on a loan whose currency you don't control - amidst relative domestic weakness - can drive a country to the brink of default.
Interestingly enough, it is the exception - not the norm - to see western central banks prioritize currency levels and their effect on EM (it is not their mandate.) In fact, during a panel discussion with Jay Powell, Christine Lagarde, Andrew Bailey and Carsten Augustin, the Fed Chair reaffirmed that despite the currency's externalities, the level of the Dollar is not one of the Fed's mandate. This is particularly true during a time where the FOMC is increasingly concerned about the potential long-term negative effects of higher for longer inflation.
Turning to data, the Bloomberg EM Total Return Index has sold off by a greater extent than during the initial Covid shock while the index's OAS spread remains very well contained. A contained OAS spread simply means that the premium the market demands over the risk-free rate for EM credit has not been blowing out -- in fact, OAS is 300bps below Covid-shock highs.
Now, if OAS is a measure of the degree of uncertainty, then whether EM deserves more repricing becomes an interesting question.
Not all of EM is created equal, however; depending on country-level circumstances, including credit history, resource-dependence and political (in)stability, investors decide to extend or not extend credit.
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Brazil CDS, despite the country's resourcefulness, is setting new cycle highs.
EM financial conditions may become incrementally tighter as central banks continue to fight inflation. However, things don't move in a straight line as the job market - a lagging indicator - will more likely than not enter a more challenging phase. The Fed is 'able' to tighten as long as the financial system works reasonably well, the treasury is not yet 'screaming' and the labor market remains relatively tight (near maximum employment.)
Another factor important to consider: as the things evolve and central banks assess the post-Covid world, their own assumptions may well change and therefore impact how they view various economic indicators (labor force participation declining etc.)
One of the more interesting dynamics besides credit spreads blowing out across EM is the diametrically opposite behavior from China's markets. China went into recession before the rest of the world even got close and the Chinese stock market has outperformed U.S. stocks ever since April. The country may take advantage from reduced demand in the west and therefore underpin commodity prices for longer.
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