Chart of the Week - Emerging Tranquility

Are we entering a new great moderation for EM? Or is it just a contrarian signal...

Our EM risk pricing indicator has dropped to one of its lowest readings ever — in other words a deep sense of calm and complacency has taken hold.

This kind of serenity and tranquility is great if you’re at a health spa or on vacation, but in markets it can be a dangerous contrarian signal.

But what exactly are we looking at here, and is it actually a bad thing?

The indicator below takes the average z-score of Equity implied volatility, FX implied volatility, EM corporate credit spreads, and 5-year sovereign CDS pricing.

So it’s a fairly holistic and cross-asset snapshot of risk pricing sentiment for Emerging Markets.

It spikes during times of stress and panic.

It drops when things are improving, sentiment is bullish, and markets are calm.

And well, things have actually been improving for emerging markets…

• The Fed is done with rate hikes for now

• USD has peaked for now

• EM central banks are pivoting to rate cuts

• Inflation is under control for now

• and the global economy appears to have avoided recession

Furthermore, the push lower in EM risk pricing also represents an easing of financial conditions — and can drive a self-reinforcing improvement in macroeconomic conditions.

All sounds pretty good, and generally supportive for the bullish EM equities case.

But by now some of you would have looked at the chart and noticed that when it gets down to these levels it doesn’t seem to stay there long (except for the mid-2000’s great moderation — and a repeat of that sure would be the bull case).

Indeed, this kind of complacent risk pricing could be considered a contrarian signal. Certainly at the very least it represents very little risk premium or pricing of any deterioration in macro conditions.

Indeed, if inflation flares up again, the USD pushes higher, the Fed stays on hold or even has to lean hawkish again… not to mention the downside risks in China, things could unravel pretty quickly in the chart below.

So what do we do with this then?

I think we acknowledge the good things going on that should be helping EM assets, and generally have a bias for bullish positions in EM assets — but equally keep a keen eye on risk and one foot out the door in case things turn the corner again.

Key point:  EM cross-asset risk pricing has reached extreme lows, complacency.

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Topics covered in our latest Weekly Insights Report

Aside from the chart above, we looked at several other charts, and dug into some intriguing global macro & asset allocation issues on our radar:

• Global Market Check: global equities, fixed income, FX, commodities

• Risk Pricing: checking in on CDS, credit spreads, volatility trends

• Commodities Outlook: reviewing the sentiment + technicals setup

• Macro Radar: key events and data to keep track of this week

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Thanks for your interest. Feedback and thoughts welcome.

Sincerely,
Callum Thomas
Head of Research and Founder at Topdown Charts

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