Rarely has the choice facing the emerging market investor been so stark.
Bonds are so richly priced that around 30 per cent of the entire universe of euro-denominated EM debt, with a face value of about €115 billion ($197.5b), now trades with a negative yield, according to calculations by investment bank Morgan Stanley. That has never happened before.
What is more, not all of this negatively yielding debt consists of short-maturity bonds issued by the EU sovereigns of eastern and central Europe, which are usually considered "safe" by fixed income investors.
The bundle includes Polish government debt at a maturity as far out as 2026, along with bonds from Indonesia, China and South Korea. The sub-zero club even includes Mexico, which is run by a leftist president who has already renegotiated contracts with foreign investors, whose vast state-owned oil company Pemex is rated "junk" by Fitch Ratings, and which is skirting dangerously close to recession.
One-fifth of the negative-yielding EM debt comes courtesy of corporate issuers, such is the demand for income from investors grappling with vanishing yields in the eurozone's core.
At the same time, emerging market equities are in desperate need of some friends.
Around 30 per cent of stocks in the MSCI EM index now trade below their book value, according to Goldman Sachs.
This is the most distressed valuation for a decade and the lowest level ever outside a US recession, the investment bank says. The entire MSCI Korea index, a benchmark heavily dependent on the health of global trade and economic growth, has dipped below 0.8 times book value this year, reaching its lowest levels since 2001. It is currently trading slightly higher, at 0.84 times book value.
Given the state of the world, it is hard to think of an obvious catalyst to bring these glaring anomalies back into order.
The European Central Bank seems determined to unleash another wave of quantitative easing, despite indications that each new round of bond-buying delivers less marginal utility than the last.
This will be likely to push eurozone bonds ever deeper down the rabbit hole of negative yields, further intensifying the search for alternatives, as will expectations for more monetary easing by the US Federal Reserve. Barring a resolution of the US-China trade war, it is hard to see an obvious catalyst to drive meaningfully higher global growth, which would pep up EM equities.
Logic might dictate that some degree of reversion to the mean in both equities and bonds is inevitable, however, even if the path to such an outcome remains murky.
An index operated by Bank of America Merrill Lynch suggests that such a moment could be nigh. The bank's Bull & Bear Indicator, based on factors such as asset allocation, flow data (including via its own trading desk) and futures and options pricing, has just flipped into "extreme bearish" territory, triggering a contrarian "buy" signal.
According to David Hauner, head of EM cross-asset strategy and economics at BofA, this is the 17th time this has happened since 2000. On each of the 16 previous occasions, 10-year Treasury yields rose in the ensuing three months, by an average of 50 basis points.
On ten occasions, global stocks rose in the following quarter, with a median return of 6.3 per cent. The previous buy signal, triggered on January 3 this year, saw the S&P 500 stock index rally 17 per cent in the following three months. The latest signal is a far stronger one than that of January, according to BofA.
"There are lots of reasons to be bearish, but positioning is already very bullish anyway so we have the potential for positive surprises," Hauner said.
Even Hauner is forced to admit it is hard to tell what "story" might justify any market rebalancing. He expects the US-China trade war to linger and believes it will be hard for either the Fed or the ECB to pleasantly surprise investors already expecting large doses of easing.
His best stab at answering this question is to say there are signs that the "massive drop" in global manufacturing purchasing managers' indices appears to be petering out, with activity stabilising at low levels, "just short of falling into a major recession".
What the markets do next is clearly dependent on the macroeconomic backdrop. If the US is heading into recession, as some worrywarts fear, then there is nothing unusual about large swaths of EM equities trading below book value, amid a general flight to quality.
More likely, perhaps, is that both the global economy and the markets bump along largely as they are, pending any resolution of the trade stand-off.
But any major breakthrough could have an outsized impact on EM assets. Not only would it be good for stocks and bad for bonds, but the impact would be magnified by the fact the EM equity index has a 73 per cent weighting to Asia — the most trade-sensitive EM region — which is far higher than for the major corresponding bond benchmarks.
So far Donald Trump has caused EM equity investors to grind their teeth in frustration. They are now looking to him to make their asset class great again.
Written by: Steve Johnson
© Financial Times