GMO Commentary – Metr Valuation – GuruFocus.com
Emerging market returns in the second quarter of 2022 reflected the continued deterioration in global economic and market conditions:
- Hard currency debt The EMBIG-D index is down -11.4%; index losses were driven by widening credit spreads and rising trend in US Treasury yields
- Local debt The GBI-EMGD index was also down, down -8.6%, as currency yields (-5.4%) and local rates (-3.2%) produced losses during the quarter.
As we enter the third quarter of 2022, our valuation metrics for emerging debt are more compelling than they were at the start of the quarter:
- Hard Currency Debt Ratings have improved significantly and are at very attractive levels, although adjusting our assumptions regarding current credit ratings implies moderately attractive to neutral valuations.
- Emerging currencies are currently in the neutral fair value range, as growth and inflation expectations blur attractive long-term valuation signals.
- Real Interest Rate Differentials between emerging markets (EM) and developed markets (DM) tightened slightly as emerging market and developed market rates sold off.
In this article, we update our assessment tables and commentary, with additional details on our methodology available upon request. 1
External debt assessment
The benchmark EMBIG-D spread widened 142 basis points in the second quarter, ending the quarter at 542 basis points. As shown in Table 1, the fair market multiple is the credit spread of the benchmark over the spread that would be required to offset credit losses. This ratio increased during the quarter. The multiple was 4.4 as of June 30, 2022, compared to 3.0 as of March 31, 2022. We estimate the credit multiple threshold range by analyzing the relationship between subsequent EMBIG-D credit spread returns over two years and the credit multiple historically. A level above the upper range of the threshold (currently 2.8) has always been associated with positive credit returns, while a level below the lower range of the threshold (currently 2.0) is more associated with positive credit returns. negative credit ratings over the next two years. – period of one year. This estimate of the threshold range is recalibrated on an annual basis. A level within this range would be considered neutral and the market valuation ended the quarter above the upper limit of this neutral range.
Widening credit spreads were the main driver of the multiple’s increase in the quarter, with the denominator of the multiple – the fair value spread or expected credit loss – falling 16 basis points to 122 at the end of June. Regular readers will recall that this fair value difference is a function of the benchmark’s weighted average credit rating, together with historical sovereign credit transition data and an assumption of recovery values in the event of default. 2 Turning to the second quarter, the strong overall increase in market spreads is an undesirable and non-intuitive result. The conditions under which this occurs are a combination of: 1) spreads sell more in riskier countries, reducing their duration-weighted relative membership in the index and resulting in an overall default loss lower expected for the index; and 2) spreads increase rapidly without any change in underlying credit ratings.
In case this last issue is important, we performed an exercise similar to the one we did in the early stages of the pandemic. In 2020 following the sharp rise in emerging spreads linked to the pandemic, we asked the question: could it be that credit ratings are not yet adapted to the new macroeconomic reality? In this case, we thought that the denominator of our credit multiple might be temporarily depressed, thereby inflating the credit multiple. In response, we considered “moderate” and “extreme” shocks to credit ratings and examined their effects on our final calculation. This quarter, we carried out a similar exercise, imagining general downgrades of one or two notches for each country in the index. In the first, more moderate case, the credit multiple drops from 4.5 to 3.5, still well within territory historically associated with a high probability of future positive spread returns. In the second, more extreme case, the multiple falls to 2.5, located between our two thresholds and suggesting neutral valuations. This implies well-supported current valuation multiples, since unlike the pandemic, rating agencies should be less “surprised” by the current environment.
On the rate side, US Treasury yields rose sharply and the curve flattened during the quarter, with the 10-year yield rising 67 basis points and negatively impacting benchmark yields. We measure the “cushion” (which we equate to the slope of the forward curve) of Treasury bills by the slope of the forward curve of the 10-year swap rate, shown by the lines in light font in Figure 2 Long-term U.S. Treasury yields trended higher in the quarter and the slope of the 10-year forward curve ended the quarter at 5 basis points, or 12 basis points higher. than the previous quarter’s reversed -7 basis points (the entire curve moved up about 70 to 80 basis points). This indicates that the market expects less cushion for rising rates, as the forward curve represents the path that would make an investor indifferent to holding Treasuries and cash. We consider that the lower slope reduces the forward-looking relative valuation of 10-year risk-free rates versus cash from the prior quarter.
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