Sovereign Debt: Emerging Markets Advantage

Monday, March 15th, 2010

By Frank Holmes, CEO and Chief Investment Officer

It’s not a good time to be a developed economy.

Sovereign debt is at or near the crisis point in Greece, Spain, Ireland and Portugal. It’s also a big issue and getting bigger in the United States, Britain, Japan and a number of other countries.

Mohamed El-Erian, CEO at bond giant Pimco, was right when he wrote in Thursday’s Financial Times that sovereign debt represents “a significant regime shift in advanced economies with consequential and long-lasting effects.”

Debt conditions are much better in the major emerging markets, as you can see in the chart below. In the G-20 largest developed economies, sovereign debt burdens are now at about 100 percent of GDP, while in the 20 most important emerging markets, debt represents only about 40 percent of GDP.

In the next few years, the forecast sees the G-20 ratio rising another 20 percent. In the U.S., the ratio is already at its highest level since World War II, and another $10 trillion (70 percent of current GDP) will be added over the next decade. Meanwhile, the emerging 20’s sovereign debt-to-GDP actually goes down as a result of smaller budget deficits.

Sovereign credit ratings for emerging markets are improving, while the credit ratings of developed markets are dropping off significantly. This can be seen in the chart below—of course, developed markets still have higher ratings (left axis versus right axis) but the trend is for the key emerging markets is notably upward.

Higher credit ratings mean lower costs of capital for these countries, which is a positive for economic growth in countries that are already growing faster than the developed markets.

Now what about equity prices? Historically, there has been a negative correlation between bond prices and equity prices in developed markets, in what can be viewed as a safety trade. In emerging markets, however, we see a positive correlation between bond prices and equity prices in recent years. This makes sense to us, because both of these asset classes are driven by money flows from investors attracted by improving economic prospects in emerging countries.

Emerging markets have had appeal for risk-tolerant investors because these economies are growing faster and their companies have generated higher returns. The sovereign debt issue is reducing the relative risk of investing in both bonds and equities in these dynamic markets—in this scenario, investors should consider the equities to capture the higher return.

Tags: Axis, Bond Prices, Budget Deficits, Chief Investment Officer, Crisis Point, Debt Burdens, Debt Load, Economic Growth, Emerging Markets, Financial Times, Frank Holmes, GDP, Mohamed El Erian, Negative Correlation, PIMCO, Regime Shift, Sovereign Credit Ratings, Sovereign Debt, Trillion, World War Ii
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Bonds & equities: Expect a major shift

Sunday, September 27th, 2009

This post is a guest contribution by Dian Chu*, market analyst, trader and author of the Economic Forecasts and Opinions blog.

The S&P has skyrocketed 58% since its bottom in early March, while the Dow is up 50% and the Nasdaq has surged 68% during that time. Meanwhile, bond prices led a rally as rates on the benchmark 10-year note have declined some 40 basis points since early August. This is good news for business: higher bond prices make it easier to refinance debt and stay in business.

Meanwhile, across the country, Main Street investors are weighing whether they should jump back into the market. However, the price correlation between equities and bonds of late has some argue that typically, if equities are trending higher, then bonds would head lower, and yield would be higher, due to concerns of higher inflation. This essentially describes “the Fed Model“, which is a theory of equity valuation popular among security analysts.

Now, the fact that bonds and equities in general are both firm seems to beg the question - which rally would end first - equities or bonds? This is an intriguing question which I will attempt to examine here.

A Split Personality Spells Uncertainty

Based on the Fed Model, bond yields should have an inverse relationship with the stock market in general. We can start by comparing the S&P 500 index (SPX) and the 10-year Treasury notes yield. As displayed in Fig. 1 by the two dotted trend lines, the correlation between stocks and bond yields is time-varying and, on average, negative over the last decade. Nevertheless, it appears, within the last two years, the negative correlation is more pronounced during the bear phase of the stock market from approximately May 2008 to March 2009 (Fig. 2 green circle).

This simple observation is actually supported by economic research suggesting that the lower expected inflation and the real interest rate is likely to increase the negative correlation between stock prices and bond yields; and that the sharp inverse between stock prices and bond yields in the 1990s bull market can be partially attributed to the lower inflation risk during this period.

The following are some plausible drivers of the current price co-movement between bonds and the equities market:

1. Fast money from Institutional and hedge funds is being allocated to both equities and bonds.

2. Flight from money markets to Treasuries due to the ultra-low interest rates in money markets and massive amounts of cash in the system as a result of the most synchronized global quantitative easing in history.

3. Depreciating US dollar is pushing up everything across the board from commodities, equities as well as bonds.

4. Market’s low expectation of future inflation signaled by the TIP spread of only about 1.75%. That is bond market’s 10-year expectation of inflation is now around 1.75%, lower than the inflationary expectations from 2003-2007 of around 2.5%. Low inflation expectation tends to push down bond yields and drive up the equities market.

5. Investors over-react to the “positive assertions” such as Federal Reserve Chairman Ben Bernanke statement that the recession is “likely over.”

Inflation & Interest Rate Expectations

There is often a multi-year lag between the cause (money-supply growth) and the effect (rising prices). So, even though we will probably be in the deflationary phase for the next 12 months or so, once economic growth starts kicking in, we’re bound to experience inflation.

What’s more, the current low inflation expectation of 1.75% is signaling the stock market is most likely mispriced and overvalued right now. Wider recognition of the inflation problem will eventually emerge. Inflation plus a recovery means sooner or later the Fed is going to have to start raising rates.

Higher interest rates and inflation expectations, coupled with the overvaluation in the equity markets could lead to a bear phase and the dreaded W-shape double dip economic scenario. This would mean a major decline in both the stock market and Treasury bond prices (a major rise in bond yields) and borrowing costs for companies will increase exponentially, thus further hindering future growth prospects in the economy.

Expect A Major Correction

The stock market is overvalued and due for a substantial pullback based on any measure of future earnings. Ultimately, bond yields are unsustainable long term, and must rise significantly to pay holders of US Debt for the risk of holding Treasuries against the backdrop of inflated government balance sheets, larger budget deficits, and associated interest expenses on the national debt.

It’s ironic that the takeaway from all this is that both the equities & bond market are mispriced and headed in the opposite direction over the next 24 months. Equities are way overpriced and headed for a major correction (Dow 8,000 level) is a more rational valuation even taking into account improved earnings in 2011.

Expect the 10-year Treasury yield to rise above the 5.25 level in 2011. Increased borrowing costs, a jobless recovery, the collapse of commercial real estate will provide quite a headwind for anyone thinking of making a killing in equities over the next 2 years from the long side.

Bottom Line - Portfolio Repositioning

Start investing in alternative investments like residential real estate, which is where most of the smart money will seek outsized returns, as slowly but surely the favorable long-term demographics start to kick in, as the population increases, excess housing inventory evaporates completely providing for a housing squeeze in 2011. Real estate is actually the best inflation hedge of all, as they call it “Real” for a reason, unlike the US currency.

Source: Dian Chu, Economic Forecasts & Opinions, September 24, 2009.

* Dian Chu is a market analyst, trader and financial writer for Zero Hedge, Seeking Alpha and Daily Markets. Her articles are also syndicated to Reuters, USA Today and BusinessWeek. Professional credentials include M.B.A., C.P.M. and Chartered Economist with extensive professional experience in market segment forecasting and strategies. She is currently working in the US in the energy sector.

Tags: 10 Year Treasury Notes, Basis Points, Bond Prices, Bond Yields, Commodities, Dian, Early August, Economic Forecasts, Equity Valuation, Fed Model, Intriguing Question, Inverse Relationship, Last Decade, Market Analyst, Negative Correlation, Real Interest Rate, Security Analysts, Split Personality, Stock Prices, Street Investors, Trend Lines
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1930s Déjà vu

Monday, September 7th, 2009

The excerpts below come courtesy of David Rosenberg, chief economist and strategist of Gluskin Sheff & Associates.

“An old contact of ours at Merrill Lynch pointed out these articles from the Wall Street Journal after the initial post-crash rally that took the market up some 50% from the interim lows. Sounds eerily similar to what we hear today:

August 28, 1930:

There’s a large amount of money on the sidelines waiting for investment opportunities; this should be felt in market when “cheerful sentiment is more firmly entrenched.” Economists point out that banks and insurance companies “never before had so much money lying idle.”

September 3, 1930:

Market has now reached resistance level where it ran out of steam on July 18 (240.57) and July 28 (240.81). Breaking through this level would be considered a highly bullish signal. General confidence that this will happen based on recent market action; many leading stocks have already surpassed July highs. Further positive technicals seen in recent volume pattern (higher on rallies and lower on pullbacks), and in continued large short interest.

Some wariness based on recent good rally recovering all of drought-related break; some observers advise taking profits on at least part of long positions, to be in position to rebuy on good pullbacks.

Most economists agree business upturn is close; peak in business was reached July 1929, so depression has lasted about 14 months. “Those who have faith and confidence in the country and its ability to come back will profit by their foresight. This has also been the case over the past half century.”

Harvard Economic Society points to steady rise in bond prices as favorable for stocks. Says there is “every prospect that the [business] recovery … will not long be delayed,” although fall period may not be strong as expected. Notes worldwide decline in business, but 1922 recovery demonstrates U.S. due to “great size, natural advantages, and diversity of conditions … can lift itself out of depression without the stimulus of improved foreign demand.”

“We only know now with perfect hindsight what these pundits did not know back then - that there was another 80% of downside left in the bear market.” Source: David Rosenberg, Gluskin Sheff & Associates - Lunch with Dave, September 4, 2009.

Tags: Bond Prices, Bullish Signal, Business Recovery, Chief Economist, David Rosenberg, Economic Society, Foresight, Gluskin Sheff, Initial Post, Insurance Companies, Lows, Merrill Lynch, Pullbacks, Resistance Level, Short Interest, Technicals, Upturn, Wall Street Journal, Wariness, Worldwide Decline
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David Rosenberg: The Case for Corporate Bonds Intact

Wednesday, July 8th, 2009

David Rosenberg, Gluskin Sheff’s Chief Economist (ex-Merrill), re-iterates his argument for corporate bonds in today’s Lunch with Dave:

While Baa corporate spreads have narrowed sharply from their Armageddon highs (and perhaps vulnerable near-term to a healthy pullback in risk appetite), at 370bps, they are still pricing in a very bad economic and financial market scenario. Moreover, this yield spread is still wider than at any point during the 2001 or 1990 recessions or the 1998 LTCM/Russian debt default freeze-up. In fact, history suggests that the corporate default rate would have to rise well above 7% for corporate bonds to deliver negative returns with yields as high as they are at around 7¼%. In a -1¼% inflation rate world, this is a hefty 8½% real rate for investors to chew on. Not too shabby. The comparable yield in the U.S. equity market, depending on whether one uses reported or operating P/E multiples on forward or trailing earnings, is a little more than 6½%.

So, corporate debt still trumps stocks, and what this 200bps ‘yield gap’ is telling us is that either corporate bond prices will need to rally more down the road or we need to start seeing corporate earnings growth recover sharply enough to pull those multiples down to more attractive levels.

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Tags: Bond Prices, Chief Economist, Corporate Bond, Corporate Bonds, Corporate Debt, Corporate Earnings, David Rosenberg, Debt Default, Default Rate, Earnings Growth, Gluskin Sheff, Inflation Rate, Market Musings, Market Scenario, Risk Appetite, Russian Debt, S Market, Target, Textcolor, Yield Spread
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David Rosenberg: Corporate Bonds Still More Attractive Than Equities

Saturday, July 4th, 2009

The following paragraphs are excerpts from Thursday’s market musings by David Rosenberg, chief economist and strategist of Gluskin Sheff & Associates in which he deliberates the investment merit of corporate bonds versus equities.

“First, while Baa corporate spreads have narrowed sharply from their Armageddon highs, at 370 basis points they are still pricing in a very bad economic and financial market scenario - still wider than at any point of the 2001 or 1990 recessions or the 1998 LTCM/Russian debt default freeze-up. In fact, history suggests that the corporate default rate would have to rise well above 7% for corporate bonds to deliver negative returns with yields as high as they are at around 7¼%. In a 1¼% inflation rate world, this is a hefty 8½% real rate for investors to chew on. Not too shabby.

“The comparable yield in the equity market, depending on whether one uses reported or operating P/E multiples on forward or trailing earnings, is little better than 6½%. So corporate debt still trumps stocks. And what this 200 basis point ‘yield gap’ is telling you is that either corporate bond prices will need to rally more down the road or we need to start seeing corporate earnings growth recover sharply enough to pull those multiples down to more attractive levels.

“We went back in time to see what the typical one-year total returns for the S&P 500 when the starting point for the P/E multiple is in a 10x-20x range and we get any sort of positive earnings growth in the ensuing twelve months, and indeed that total return growth averages out to be nearly +15%. This is why the valuation is important - when the starting point on the multiple is closer to 30x, you need to see at least 20% earnings growth in the coming year to generate any positive returns in equities at all.

“Our analysis would seem to suggest, given the multiple that coincided with the market trough, and under the proviso that we at least see some moderate positive growth in corporate profits, that the March lows will hold. Our challenge now is navigating the forecast after a massive 40%+ rally that has already occurred without any evidence of a meaningful earnings turnaround. The onus was on the bears back in March; the onus is now on the bulls.

“Our point is that the equity market has already gone beyond - by a factor of three! - what is normal in terms of the returns it usually generates in a given year when the starting point on the multiple is low to mid teens and earnings are up, say, roughly 10%. In other words, there is a whole lot of good news priced into stocks at current price levels.

“From our vantage point, a pullback towards 800 on the S&P 500 would not only be justified under the prospective earnings landscape, but would likely also provide a welcome buying opportunity.”

Source: David Rosenberg, Gluskin Sheff & Associates - Pastry with Dave, July 2, 2009.

Tags: Basis Point, Basis Points, Bond Prices, Chief Economist, Corporate Bond, Corporate Bonds, Corporate Debt, Corporate Earnings, David Rosenberg, Debt Default, Default Rate, Earnings Growth, Gluskin Sheff, Inflation Rate, Market Musings, Market Scenario, Proviso, Recessions, Russian Debt, S Market
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