FLOW CHART: The path to an emerging markets meltdown

Photo by Adam Berry/Getty Images

Concerns over the health of emerging markets, led by China, have dominated investor sentiment over the past six months.

The combination of US dollar strength, slower growth and increased indebtedness derailed what was up until recently a stellar period for financial markets.

Many are now questioning whether recent market ructions were simply an overreaction, or the start of something far more sinister.

The UBS global macro strategy team, consisting of Bhanu Baweja, Manik Narain and Maximillian Lin, have pondered that very question, presenting the excellent flow chart below to demonstrate what, if it occurs, will lead to an escalation in pain for emerging markets.

They’ve thoughtfully shown where we currently sit in the journey.

With emerging markets sitting in the “new, dangerous phase”, they offer an opinion as to what will happen next.

1. High government ownership in key sectors such as oil and gas, and financials will likely keep EM corporate credit from weakening as dramatically as that seen in US HY near term.

2. However, weak earnings, negative credit impulse, and tightening primary markets will likely hit EM corporates with a lag. Corporate fundamentals will hurt the sovereign that is backstopping them just as the sovereign’s fiscal credentials are already being questioned, leading to higher spreads and higher local yields. This should mean that the problems of one sector infect the broader economy in EM much more than it has in the US.

3. A widening of sovereign spreads and higher local yields should broaden the pain across the corporate spectrum, hurting stocks including those in strong sectors through a higher cost of equity. The link between credit spreads and equities is much stronger in EM than in DM, notwithstanding recent price action in the developed world.

4. A widening of EM financial spreads will be a key sign of contagion from corporates to the sovereign. This was the case in Europe too, except it is difficult to see an effective backstop like the ECB or Fed in EM. A negative loop between financials, sovereigns and corporates may be set in motion. This can eventually lead to fixed income capitulation, and value creation.

5. In 2016, we expect EM corporate credits to widen further by around 70-100 bps, underperforming both EM sovereigns and US HY. This is consistent with EM equities dropping 10-12%. We like DM financials relative to EM financials, are buying protection in Turkey, Malaysia and Mexico, like paying Turkey rates, and are long USD Asia.

Based on that view, it’s clear that Baweja, Narain and Lin, like others, believe the recent outperformance from emerging markets is unlikely to persist.

Should that eventuate, at least you’ll have the flow chart to uncover what happens next.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.