PIMCO's Mohamed El-Erian explains how emerging market fundamentals can be trumped, for a period, by the Market For Lemons (MFL), in part to explain how emerging market debt was affected by the GM and Ford credit downgrades.
...we received a call last month from a government official. He was looking for some insights as to why his country’s financial markets were disrupted given that the latest national data releases were than “consensus market expectations.” In response, we noted the large sell-off in U.S.autos triggered by a range of market concerns relating to earnings, legacy costs, uncertain negotiations with labor unions, and rumors about competing claims on the large cash held on the balance sheets. The official’s response was succinct: “Our economy does not rely in any way on either GM or Ford. Why should concerns about U.S. car companies impact our market?”...
Well, because investors worry that the country in question, like GM, might be also a lemon. They don't even want to deal with anyone even suspected of being a lemon.
In terms of insights: “ The paper describes the second-hand market for used cars. Some cars are in good working order—these are referred to as cherries, peaches, or jewels. Some have hidden defects—these are called lemons. Yet because buyers don’t know which cars are the lemons—under asymmetric information—in an effect that is known as crowding out, the market price of even the good cars decreases."
MFL thus explains episodes in EM when country-specific valuations get decoupled from fundamental determinants of creditworthiness. [emphasis added] Instead, the market marks them as “lemons,” with bottom-up signals getting overwhelmed by top-down influences. And, to the extent that they trade, they will do so at values that may subsequently look puzzling as fundamentals re-assert their influence...
The Market for Lemons sounds like a profitable place to be...
Accordingly, the key question for investors is whether the current prospects of relatively high yield and potential capital appreciation for several EM credits are sufficient to underwrite the inevitable top-down volatility. Our answer is yes. This is reflected in our exposure to the asset class. And the fact that some others have taken an opposite view through the use of index products has given, and will continue to give rise to an additional set of tactical opportunities.
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