Lower tail risk favors emerging markets

Fear of extreme outcomes blew up risk markets at the end of 2018, and the response of governments as well as central banks has reduced the risk of extreme options. Tail risk is shrinking, and some of the riskiest assets, for example, local-currency emerging market debt, looks attractive.

For hedge funds, the so-called carry (interest-earning) trade is king. My model says that the best risk/reward is in higher-yielding Asian currencies - Philippine peso, Indian rupee and Indonesian rupiah - due to a combination of good central bank management and favorable economic conditions.

The outcasts of the emerging market currency world, Turkey and Brazil, are also investible for the first time in a couple of years. Individual investors can get exposure to EM local currency debt through ETFs (the Emerging Market Data Base has a list).

The average cost of hedging emerging market currencies against the dollar has collapsed during the past few months. The 'volatility' in the chart below is just the normalized price of one-month options on the exchange rates of the major EM currencies.

There are as many reasons for the risk decline as there are countries. Brazil's 2018 elections brought a free-market government to power that has impressed investors. Turkey has ended its standoff with the United States, and the country's volatile president has left monetary policy to the competent central bank. The Philippines have raised interest rates to control inflation, with apparent success.

Turkey, the Philippines, Indonesia and India all benefit from lower oil prices. But a key global reason for falling risk is the Fed's eleventh-hour realization that tightening monetary policy in the face of a deflationary world environment is not a clever idea.

The convergence of riskiness between the US and emerging market stock markets during the past five months is also remarkable. Back in August, the implied volatility of options on the EM Equity Index ETF (EEM) was roughly twice that of the S & P 500 (the VIX index). Now they are roughly equal. You can buy the S & P for 18 times earnings, or EEM for 12 times earnings, with the same risk. I continue to like Chinese and Southeast Asian stocks, anticipating a US-China trade deal.

I realize that the picture I draw of shrinking tail risk is quite different with some of the rhetoric coming out of the financial community. This morning I heard former Bank of England Governor Mervyn King warn that the ratio of debt to GDP worldwide stood at an all-time record. One hears this all the time. But the world debt situation is remarkably benign compared to 2008.

Between 2001 and 2008, world debt (excluding China) nearly doubled, as the chart shows. Between 2010 and 2018, world debt (excluding China) rose by just 18%.

I leave China out of the calculation because it's a special case. China took on massive amounts of debt, mainly through the balance sheets of state-owned enterprises, to build infrastructure, including a network of high-speed trains that exceed 29,000 kilometers in 2018. I discussed China's debt in some detail in a Jan. 18 column .

There simply isn't much of a debt overhang in emerging markets. Brazil has enough foreign exchange reserves to buy back all of its foreign-currency debt. There is plenty of political risk in emerging markets, but the largest economies have improved their management in recent months (except for Mexico, ruled by an incompetent populist, and South Africa).

Less adventurous investors might consider US corporate bonds. They yield somewhat less than they did at the end of the December panic, but still offer acceptable risk/reward. The most important thing to know about US high yield debt is how dependent prices are on the energy market. Energy debt is a sufficiently large portion of total issuance to whipsaw the market.

During the last few months of 2018, the cost of hedging the oil price (the implied volatility of oil options) had a big impact on the market. As the oil price fell and the cost of hedging rose, high yield spreads blew out. The chart below shows what happened in the oil and HY markets during the five months through Jan. 23:

The biggest tail risk to the world economy - at least in the minds of financial pundits - was the Chinese economy. I never believed that Chinese growth was at substantial risk, but if (hypothetically) Chinese growth dropped substantially, the impact on oil demand would be substantial. Yet China continues to grow comfortably above 6% a year, and oil imports continue to grow on an accelerating trend.

With a few exceptions, I'm not a big fan of equities. It isn't the state of the world economy, but the valuation of market leaders, that continues to worry me (see Seventeen Reasons to Hate the Stock Market , Dec. 18, 2018).

It's hard to have confidence in a market that today bid up IBM by 9% on a favorable profit report, but knocked down Capital One Financial by 6%. The market's hypersensitivity to quarterly profit results and management guidance bespeaks a great deal of uncertainty about what stocks are worth.

But it's a good environment in which to earn interest.

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