So on Saturday in “How Is This Even Legal? EM Debt Fund Cash Balances Hit 4-Year Lows,” we noted the rather disconcerting trend in EM debt fund cash levels, which are approaching multi-year lows on the assumption that inflows into these funds will continue.

Note we used the term “assumption.” If that assumption turns out to be wrong, then it’s not 100% clear to me how these funds are going to deal with outflows without selling the underlying bonds which leads directly to questions about how liquid the market for those bonds actually is.

We’ve raised similar concerns about HY debt funds on any number of occasions this year.

Well, in this context it’s worth looking at how EM has performed over the past couple of weeks relative to USD HY as bouts of risk-off sentiment tied to North Korea jitters and Trump’s stumbles have weighed on markets.

Here’s EM bond spreads versus HY spreads:

Same dynamic in returns:

The assumption – or maybe we should just call it “the easy answer” – here is that investors are simply more confident in the outlook for EM (and by extension the carry trade) than they are about the outlook for U.S. junk.

But as Barclays notes, these charts might not tell the whole story because if you look at CDX EM, the short base is at a record.

The benign global macro environment alone, however, may not fully explain the relative outperformance of EM versus other risk assets, for example the recent outperformance of EM versus US credit.

Positioning factors may also have played a role, in our view. Solid and persistent flows into EM funds suggest that investors have not been shy to engage in EM. However, below the surface, there appears to be some hesitance by fund managers to position aggressively. One indication of this is the short base in CDX EM by investors that has steadily built up to new record levels over the past few weeks and notably contrasts with the significant net long risk base in CDX HY (Figure 2).

 

 

Something to keep in mind for EM investors as we head into Jackson Hole.