Credit risk in emerging markets has long been mispriced as the impact of unprecedented monetary stimulus and record low policy rates seemingly placated concerns about higher leverage. However, with the rise in US rates claiming its first casualties (Argentina and Turkey), EM credit risk is starting to normalise in line with fundamentals. The chart below shows the 12-month range of the benchmark 5-year CDS for the major emerging markets. In most of cases the cost of default protection is at or close to the 12-month high and in every case bar South Korea the CDS trades in the top quartile of the 12-month range.

While the focus is invariably on Argentina and Turkey, which are still having their ‘crisis moment’, EM risk re-pricing will throw up new opportunities to be short credit. Given that we believe Italy’s credit risk has been inflated by political noise (which will subside), the CDS (trading at 253bps) serves as a useful benchmark for evaluating short EM credit candidates. As the bottom-left chart shows, with the exception of Argentina, Turkey and Brazil, emerging market CDS spreads trade inside Italy, eg South Africa, Russia, Mexico, Indonesia and Colombia. We would expect this mispricing to correct, and for Italian CDS spreads to narrow relative to the EMs listed.

(Click on image to enlarge.)

Source: Bloomberg, Macrobond and Variant Perception