LONDON (Reuters) - Emerging market credit turbulence has further to run in 2016 and investors are better off looking to profit from mispriced U.S. assets, the head of research at hedge fund CQS said on Tuesday.
While concerns around Chinese growth and the impact of a probable U.S. rate rise saw emerging market stocks and bonds sell off in 2015, Matthew James said it was too early to buy back in given the structural changes still being worked through.
“Emerging market dollar borrowing, in terms of the stock, is bigger than the U.S. high-yield market, and the bulk of this growth has occurred in the last six years,” James told the Reuters Investment Summit in London.
“It’s basically grown at least five times - that in itself should send warning signals.”
Given one of the drivers of that growth has been quantitative easing pushing investors to look for yield in riskier areas, the prospect of rising U.S interest rates could see investors not committed to the trade pulling money out.
With many investment banking intermediaries having shrunk in the meantime, “the exit door is at best the same size, if not a little tighter, and you have a crowd of money - $1.5 trillion, roughly - that may shift.”
The move, which could take place over a six-month period or a 36-month period, would be an opportunity for global credit investors, he added. “Those assets will find a home, (but) it may not be at the price they’re at today.”
James said he thought U.S. Federal Reserve Chair Janet Yellen would announce a 25 basis points rate rise in December and then do so twice more in 2016.
While a dollar bull, James said he was “less enthused” about U.S. stocks, which have only flat-to-very-slight revenue growth, margins which are at best stable, rising leverage, a reduction in the impact of share buybacks and an increase in mergers and acquisitions driven by economies of scale and cost savings.
James said he was more interested in credit spreads in the U.S. and Europe, where the gap between the widest and tightest spreads was three times that of 12-18 months ago and the correlation of single names to their index had dropped a lot.
“Both of those combined make it a credit picker’s market ... if you are ... good at picking individual credits both long and short, 2016 will be very attractive.”
That would in turn be fuelled by structural changes to the industry which have created more mispricings as investment banks take less balance sheet risk.
While that has led to concerns around market liquidity in some quarters, James was not convinced.
Despite the “complaining” about reduced liquidity, James said it was now very similar to what it was like in 1995 to 2005, where markets functioned perfectly normally. To deal with it, investment managers needed to change how they trade.
As well as taking longer to enter and exit positions, price anomalies would persist for longer, he said.
“Which works both ways: you have more time to jump in, but you could jump into a cheap asset that stays cheap a while. You need to look for trades where something is cheap and you have catalysts for it to revert to the value you expect.”
While U.S. high-yield credit was doing well he did not expect a mass of defaults. Retail and energy were both sectors which could see increased capital restructurings in 2016.
“With energy, we seem to be having a default cycle start up that’s sector specific and sector driven... Unless we get a massive, and unexpected to me, extend and pretend (by lenders)... you’re going to see capital structures adjust.”
While there was a lot of money from private equity and distressed debt funds waiting on the sidelines to pick up cheap energy assets, however, James said it would be interesting to see how eager those funds were to put it to work.
“A lot of players in the market really didn’t go through the last default cycle and didn’t see how price action (developed). The fact that something goes from 90 to 50 doesn’t mean it can’t go to 10.”
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Additional reporting by Carolyn Cohn