South America’s second largest economy has been a favoured story among EM investors and even though fundamentals remain benign, volatility and technicals have intensified price action.
Volatility in emerging markets continued to spike in the past week, with investor attention focused on Argentina, where assets remained under pressure following a 10% fall in the value of the peso last week. Even after hiking interest rates to 40%, commencing discussions with the IMF regarding a US$30bn credit line and announcing a number of fiscal measures, investor confidence remains badly shaken. In hindsight, it is clear that Argentina has been a favoured story among many EM investors and even though the fundamental story seems to have changed little, rising volatility has triggered position reductions, further exacerbating adverse price action. Elsewhere, Turkey has come under pressure as the central bank resisted pressure to hike rates as the currency fell and more generally it appears that an attempt to de-risk portfolios has led to negative price performance across the EM asset class. On reflection, it appears that consensual positioning and investor complacency have sown the seeds of this sell-off and it seems like the clearest lesson to be learnt here pertains to how asset classes can decouple and how volatility can jump erratically following periods when it has been very subdued by historical standards. For example, it is noteworthy that the EM Local Currency Bond Index has dropped 6.5% in the past three weeks, in a period when US Treasuries, high yield and equities have been broadly unchanged.
We believe that policymakers in countries like Argentina are now getting ahead of the problem and that position cleansing should be close to complete. In this context, hopefully there will be an end to the ‘Argy-bargy’ and stress should recede.
In the US, higher oil prices following the scrapping of the Iran deal has seen 10-year Treasuries flirt with the psychologically important 3% level in recent days, even as the geopolitical backdrop has grown more worrisome. Otherwise, price action in core rates has been relatively subdued with all of the action taking place elsewhere. Political developments in Italy have seen Italian government bond (BTP) spreads widen as a Five Star/Lega coalition government has become more likely in recent days. Such an administration may deliver some measures on VAT and pensions’ leading to fiscal slippage, but investor concern is likely to be more squarely focused on the likelihood of electoral law reform, paving the way for new elections in 2019 where a clearer winner is more likely to emerge. In such a case, it seems that investors are fearful of a Five Star administration, though we believe that such risks may be exaggerated by those who always tend to have a bearish European bias and a tendency to look for monetary union break up trades. We don’t currently have a strong view on BTP spreads and believe that 10-year bonds are likely to remain in a range between 110bp-150bp on a spread basis relative to Bunds for the time being. Elsewhere, in the periphery, we remain very constructive with respect to dynamics within the eurozone and continue to believe that Greece offers the most compelling value in the space.
US dollar strength has been a dominant subject over the past month, with interest rate differentials the ascendant theme within FX markets. Since the start of the year, we had thought that 2018 was unlikely to see a re-run of 2017, when the dollar traded softer throughout the year. In 2018 we have had a view that there would be distinct periods of dollar strength and other periods of dollar weakness. We are currently in the middle of a strong dollar phase and suspect that this may have a little further to run. However, we are disinclined to extrapolate trends too far and would see levels much below 1.15 versus the euro and 115 versus the yen as relatively unlikely to be sustained. Consequently, we remain modestly overweight in the dollar for now, but this is a relatively low conviction view.
Credit markets have continued to be relatively immune from the EM turmoil since the start of April. Having underperformed in February and March, corporate spreads appear to have been supported by solid earnings and appetite for yield, with the high yielding part of the market outperforming in both the US and eurozone. Dynamics in sovereign credit have been much more challenging with the re-pricing in EM leading to widespread weakness in spreads in those names impacted by negative newsflow. In this context, flows and technicals seem to be having a disproportionate say over short-term moves in prices, yet ultimately we are aware that fundamentals will dictate value and in credit this is even truer than in other parts of the market, where there may not be such an obvious valuation anchor.
Looking ahead, we continue to argue that little has changed in the fundamental backdrop. We believe that policymakers in countries like Argentina are now getting ahead of the problem and that position cleansing should be close to complete. In this context, hopefully there will be an end to the ‘Argy-bargy’ and stress should recede. As voiced earlier, it seems that a clear take away from recent events is that investors need to be prepared for spikes in volatility and the absence of liquidity. This is something we have witnessed several times already across global financial markets in 2018 and ensuring that portfolio positions are ‘right sized’ to withstand volatility is going to be very important in our view. It may be early to debate where volatility may show up next, but it strikes us that wherever there is complacency then this may represent a structural source of vulnerability. In hindsight, the fact that a crack like this happens to have occurred in a currency named the ‘ARS’ sounds like it was tailor-made for the tabloid headline writers all along. Yet when events like this occur, the re-pricing and value destruction that comes with it, creates in itself value opportunities elsewhere. So ‘don’t cry for me Argentina’ and let us look for the opportunities such episodes may offer.