One week / one topic: Brittle joys

What happened?

Looking at stocks’ performance since February 27th, you could be excused for asking: ‘War? What war are you talking about?’

Global equities sit at fresh all-time-highs, earnings growth expectations remain rosy, and summer is allegedly around the corner.

Woo-hoo.

Bond markets, however – with their characteristically grumpier disposition – are saying something else. The different yield moves in the US vs Europe (and UK) are indeed quite telling of the underlying set of beliefs.

Since the first attacks on Iran, US 2-year breakeven rates are ~11 bps higher and 2-year real yields rose by ~29 bps. Extrapolating, the impact on inflation is then expected to be fairly muted and the Fed is seen as able to successfully control this through a moderately more restrictive stance.

Inflation-fighting credibility remains broadly intact. I.e. not cutting rates should suffice in managing this situation, without a meaningful impact on growth resilience.

In Europe, the situation is quite different. 2-year breakeven rates shot up by ~100bps and 2-year real yield collapsed by 47 bps.

Not only the expected inflationary impact of the war is much larger (breakevens up); markets have also aggressively repriced a policy reaction (nominals up) without generating confidence in growth (real rates down).

Zooming out in terms of longer timeframes and geographically as well, there is room to make further observations since – while 10yr nominal, real and breakeven rates have moved up across the board – there are stark differences across countries.

The UK, Italy, France and South Africa displayed the largest vulnerabilities to this shock, with large increases in both breakeven and real yields.

Following the shock, investors now demand a higher risk premium given high debt loads, impaired policy credibility and dependence on energy imports.

At the other end of the spectrum, Brazil really stands out as its 10y nominal yield is up only 16 bps (the smallest move in the sample) and that modest rise is mostly breakeven‑led (+11 bps breakeven vs +5 bps real).

Extrapolating, the market is pricing a mild inflation‑compensation uptick without a meaningful reassessment of the long‑run real stance.

Given the recent resolve demonstrated by the Banco Central do Brasil, one is left to wonder: is this what central bank credibility looks like?

Are there any wider implications for Brazilian assets, and for how to manage overall exposure to emerging markets (EM) vs ever-deteriorating developed ones?

Our observations

• Fundamentals: While the reaction at the front end is redolent of ‘US exceptionalism’ once again, perhaps the recent move is more interesting through the lens of Brazilian assets and EM more broadly.

  Cheaper valuations and very high real yields in Brazil are bolstered by renewed global flows into LatAm, creating a supportive backdrop for local equities, bonds and the currency at the same time.

• Price action: It has been hard to miss the across-the-board outperformance in Brazilian assets, and EM more broadly.

  However, as noted before, price moves can extend much further than you’d expect – and especially so in EM.

• Investor beliefs: The actual difference between DM and EM countries – and the attractiveness of their respective financial assets – has been more and more in question lately.

  While narratives are conveniently created following price moves, it feels like it might take significantly more to dislodge longstanding skepticism about EM and turn it into a consensus trade…

So what?

A recurring question for us over the years has indeed been about differentiation between DM and EM assets.

On top of multi-year positions in local currency EM government bonds, we have also built conviction positions across EM equities over time.

While this has served us well, the question of ‘how would EM assets behave in a true risk-off event?’ remains central – and this is where things get tricky.

Given that there are only so many sufficiently liquid alternatives available – and that holding elevated cash positions for long is not really an option – you could translate the question to: ‘would EM assets meaningfully underperform DM ones in a crisis?’.

While every market-moving event is different, the recent shock of the Iran war is nonetheless useful in teasing out the market’s revealed preference and underlying set of beliefs.

The differentiation is clear: while Brazilian assets have outperformed, this has not been the case for broad EM indices.

And yes, I know… ‘emerging markets’ is a misnomer for a set of countries that are wildly different from each other.

But shouldn’t this be precisely why you don’t want to dismiss (or adore) EM wholesale, and indeed keep looking for opportunities?

Mood music: Bon Iver – S P E Y S I D E

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