There seem to be two main factors driving this EM rally and the move in equities more broadly. The first is the stability in the US dollar, which, contrary to all consensus wisdom, has stopped appreciating. The second driver has been the drop in interest rates. More than a third of all sovereign papers globally are now yielding negative rates, and rates across all EMs and corporate assets have come off. There is a mad rush for yield. Just witness the demand for masala bonds! EM debt issuance is breaking all records. The conventional view is that rates globally will remain low forever, and thus, one must chase yield and take whatever yield is on offer, no matter how risky.
But is the consensus right about yields remaining low forever? What are the risks to this view? A change in perception can damage markets and sentiment severely. A slight rise in yields can create panic and shake investors out of their complacency. Is there any reason to doubt the current low-rates-forever consensus?
If one looks at market signals and price action, there is some reason for concern.
Take for instance gold and silver prices, they have stalled for the last few months, with silver actually down. If rates were going to remain low forever, would prices of these precious metals not be rising? Why have they stalled?
Secondly, on inflation, it is quite clear that headline inflation in the US will rise in the coming months, driven by rising energy and shelter prices. Base effect alone will take headline consumer price index (CPI) in the US towards two per cent, core CPI is already there. Is the market ready for this jump in headline inflation? Can it spook the bond market?
Interest rates have already started to inch up. Japanese government bonds (JGB) yields are up about 30 basis points in the last few months. Surprisingly the three-month London Interbank Offer Rate (Libor) is also up from 25 basis points to over 75 basis points. One-year Libor is now over one per cent. These moves are partly related to changes in accounting rules for money market funds, but nevertheless, something to watch and keep track of. All markets seem to have just ignored this rise in Libor. Everyone expects these rates to come back down by October. What if they do not normalise?
Price action in the equity markets is also throwing up contradictory signals. Financials have been rising in the face of falling yields. Since July, financials have outperformed quite significantly. Maybe it is a dead cat bounce, but normally, financials should not do well with flattening yield curves. Similarly, the bond proxies, utilities, real estate investment trusts (REITS) and telecoms have done poorly through the summer, as yields have dropped. Again, not what you would expect if rates are going to stay low forever. Bond proxies should rise – not fall – with falling yields. This price action only makes sense if equity markets are sensing that rates are headed higher. There seems to be a clear divergence between the bond and equity markets. Bond markets and their investors are saying that low yields are here to stay for the foreseeable future and yields can only go lower. Take whatever yield you can get, wherever it may be, and sit tight. Equity markets seem to indicate through their sectoral price action that yields may be headed higher. Who is right? Given the current consensus, my bet is that yields will rise, if even for a short period.
If yields do head higher, as some of the market signals are hinting at, this will be a definite shock to fixed-income markets. It will cause short-term market dislocation, and spread fear and panic as investors change their positioning and leverage unwinds.
This is not the time to chase yields and put on leverage to enhance returns. One should be very careful with your fixed-income portfolio and shorten duration. Book profits wherever the returns have been disproportionate.
A fixed-income shock will rattle equity markets as well. Interest rates will rise, at least temporarily, and the dollar may once again strengthen as investors herd into safety assets. Both the pillars of the current EM rally, falling yields and stable dollar may reverse in the short term. The damage will be short, sharp and swift. In any EM correction, India will also fall. The damage in the mid-cap space can be quite intense. While India remains in a structural bull market to my mind, one should be careful in the short term. Positioning and consensus globally seem too much one sided. No one can even contemplate rates rising. That is probably why they will.
The writer is at Amansa Capital. These views are his own