Adam Smith, the great eighteenth century Scottish moral philosopher and economist, once eloquently espoused in his great work ‘The Wealth of Nations’ that all nations default on their debt. All governments do this at some point, whether in the form of outright default, or debt re-scheduling or moratoria or a gradual default through devaluation of the currency.
Remembering that every asset has its time and place, then now might be the time for Emerging Market assets – particularly bonds, both Sovereign and Corporate. Governments of developed nations have been trying to stimulate their way out of crisis and the tendency so far has been for all this liquidity to find its way into other markets including Emerging Market assets.
The size of the liquidity wave has been so huge that a rising tide has lifted all boats, but if capital flows start to become more discerning, the relative attractiveness of each asset will become a key factor determining immediate and longer term direction.
Bond markets outweigh equities 10:1. With USD10 trillion tied up in US Treasuries, that is a major potential source of capital flow into emerging market bonds; especially bonds denominated in local currency which now face the possibility of a twin bull market of both rising currency and bond price appreciation.
In China, where strict capital controls are imposed on foreign capital entering the country, authorities are now opening up channels for investment in local currency denominated bonds, both Sovereign and Corporate with McDonald’s being one of the first to take advantage of this by launching its first bond denominated in Yuan. Other corporate bond issues are likely to follow.
Thailand has seen inflows from June to September of as much as USD30 billion, more than the whole of 2008 and 2009 combined. This has caused the baht to rise by over 10% against the US dollar despite aggressive attempts by the Bank of Thailand to weaken the baht by buying up dollars in the foreign exchange market and accumulating reserves that have doubled in just two years to over 150 billion dollars. The strength of the baht is causing some concern among the exporting business community prompting the Bank of Thailand to revoke the exemption of a withholding tax for foreign holders of Thai sovereign and government agency bonds of 15% on interest and capital. The results overall has been limited so far as only 10% of the bond market is owned by foreigners with the baht still hovering around THB30:USD1 despite the fact that foreign participation in the market has reduced by seventy percent.
An interesting aside to this was the debate between emerging market bonds expert Simon Godfrey of BNP Paribas and economist Robert Jukes of Collins Stewart at the recent International Advisor Plenary Sessions in Singapore. Simon Godfrey maintained that bonds such as Thailand’s sovereign and agency bonds not only offered better yields but also arguably less risk than their US equivalents. “On the contrary,” says Jukes, who insisted that all emerging debt is still a ‘risk asset’ and, in a crisis, yields tended to widen as perceptions of risk would attach to emerging debt whereas developed market debt would be seen once again as a safe haven. It is true that while initial perceptions may lead capital to seek safety in US T-bills, ultimately a new order may emerge that recognizes the different realities of indebted developed countries as opposed to faster growing, unleveraged emerging economies.
However, not all Emerging Markets are made the same. Certain country specific risks exist and chief among them is the rule of law and political stability. You only need to look back to 1998 and the Russian Bond Default that resulted in the collapse of Long Term Capital Management. LTCM was a famous hedge fund formed by Nobel Laureate academics that probably should have left their expertise confined within university walls. Due diligence and caution are always required and maybe at this time patience and nerves of steel as well if a seismic transfer of the balance of economic power takes place in the battle ground of bond markets. Counter it with diversification.
The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]