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BE CAREFUL IN CATCHING THE EMERGING MARKETS FALLING KNIFE
or at least be selective in your picks
It is barely a few months since we got worried about a new wall of money heading to emerging markets on the back of quantitative easing by the Bank of Japan and lingering doubts about the strength of US recovery. This sentiment has entirely reversed in recent weeks, in particular since markets have begun to price in the end of Fed asset purchases.
It’s a bit ironic that the large emerging markets countries, which complained about monetary easing in the US (Brazilian Finance Minister Guido Mantega called it ‘currency war’), are now the hardest hit when talks about tapering QE are hitting the headlines. Be careful what you hope for. Brazil recently had a massive weakening of its currency and the central bank had to hike rates to defend the currency. Not good for their already struggling growth…
Emerging markets assets – currencies, bonds and credit – have all come under significant selling pressure since mid-May. Earlier on the softening in EM activity and lower inflation pressures in April encouraged emerging markets central banks to resort to monetary stimulus once again, pushing front-end rates lower. In addition, bonds and currencies rallied in anticipation of capital inflows following the BoJ easing. So by early May yields had declined to well below the level that the typical relationship with G3 yields would imply and EM currencies had rallied despite narrowing interest rate differentials. All of a sudden a quick sharp rise in US yields caught EM assets by surprise. Even more so, since the move was steeper as far as real yields were concerned, inflation expectation has been coming off at the same time. As local currency rates premiums (local currency versus Dollar-denominated sovereign yield spreads) compressed on the back of higher US rates, currencies weakened rapidly. Moreover, the starting point – one of EM FX relative strength, recently exacerbated by the mentioned BoJ-induced euphoria – implied that there was some catching-up to do. EM currency weakness quickly translated into a broader EM asset sell-off (including bonds and credit) and the moves across EM assets have been quite large. Amid such violent price action it is easy for excessive concerns over rapid capital outflows and exponential price action to prevail. Of course, as it usually happens at times of excess volatility and positioning unwinds, weakness in EM assets may well become idiosyncratic. And there is room for EM assets to sell off further. Things are not made easier from the fact that this sell-off is hitting on generally fragile and fearsome markets, already being put to the test from horrific price action in gold a few weeks ago and in the Nikkei pretty much at the same time. Generally risk aversion has been woken up by rising interest rates markets volatility.
Trying to put events a bit more in a cause-and-effect logic we could identify three concomitant reasons behind the current debacle:
- ‘Taper talk’ from the Fed (i.e. Federal Reserve recognition that US economy is alive and resilient despite all “Fiscal Cliff” worries)
- Disappointing EM growth, especially in the biggest (BRICs) economies
- Crowded positions in this asset class after years of ‘search for yield’ in global portfolios
Emerging markets growth disappoints
The fact that EM growth has turned a lot less appealing at this juncture has certainly contributed to the ongoing deleveraging. In fact market sentiment towards emerging markets is also being negatively affected by lingering concerns about the outlook for the biggest emerging economies.
Chinese GDP growth in Q1 (7.7% YoY) was marginally lower than expected and more recent data, including industrial production and the PMI surveys, have also been on the disappointing side. The new political guide seems to be serious in trying for real to rebalance the economy from export/investment to driven by domestic demand before it is too late. And this likely means accepting lower growth and more suffering in the financial and banking system compared to the past.
India’s economic performance has been subdued. GDP growth was again below trend in Q1 at 4.8% YoY, industrial production grew by just 2.0% YoY in April, and the May PMI survey measure declined to a barely expansionary 50.1.
Growth in Brazil has also fallen well short of expectations so far this year. GDP grew by 0.6% QoQ, mainly reflecting weak household consumption and a large negative contribution from net exports. Weak growth, rising inflation, and a widening current account deficit, had all suggested that Brazil had reached the limits of its consumption-oriented growth model.
The Russian government was recently contemplating how to stimulate its flagging economy, which has been growing at an annualized rate of 1.3% for the last two quarters. Few concrete measures have so far been agreed. This is undoubtedly disappointing as far as the structural reform agenda goes, which holds the key to greater foreign investment and higher growth.
As a consequence sell-side research has been lowering their economic forecast for EM growth. Chart 1 shows Deutsche Bank case.
Positioning and cumulative inflows are not trivial
As can be seen from Chart 2, courtesy again of Deutsche Bank, after the Great Financial Crisis, with developed economies desperate to keep interest rates at their lowest levels in history, the Emerging Markets financial markets benefited big time from money searching for a decent yield.
Inflows have been significant especially in Local Currency debt markets, which obviously involves exposure to EM FX, as can be seen in JP Morgan Chart 3.
Aggregate capital flows to emerging markets have accelerated in the last year or so. Even if they are still well below the levels seen in 2010 there has, however, been a shift in the composition of flows towards portfolio investments, especially in bond markets, where foreign participation hit record levels in some cases earlier this year. Recent movements in exchange rates seem to reflect this, weakening most in countries that have received significant shorter-term inflows over the last year. Fundamentals seem to have mattered less.
Putting the move in context: not as bad as it feels
Even if current volatility reminds us of very dark periods like the one marked by the Lehman debacle, the current drop in EM assets prices has not been so terrible so far if compared with past crises. In the end the financial system has now in place many more backstops and liquidity safety nets than in those days of the recent or distant past. At the same time while looking at the following charts it may be a useful reminder that catching a knife while it’s still falling could be a painful mistake, since now this asset class is likely even more crowded than back then.
The charts below are of two famous investment vehicles, being amongst the most popular ways used to invest in these markets. It could be a good proxy of the real performance of a portfolio invested in Emerging Markets bonds.
PIMCO Emerging Local Bond Fund is an open-end fund incorporated in the USA. The Fund invests in at least 80% of its assets in fixed income instruments denominated in currencies of countries with emerging securities markets.
Templeton Emerging Markets Bond Fund is a SICAV incorporated in Luxembourg. The Fund invests primarily in debt obligations of emerging market issuers. It invests in fixed-income security papers of publicly traded companies in emerging markets and may also invest in bank deposit papers.
Stay away or buying opportunity?
Obviously it is not an easy question to ask, especially in the middle of the dust after the recent blast. Comparisons with 1994’s fixed income meltdown (which triggered several EM crises from Mexico, to Asia and Russia in the following years) or the 2008 Great Financial Crisis are difficult. In the end, as far as fiscal parameters and debt overhang levels are concerned, EM countries can still show much better fundamentals than Developed Markets (DM). That was definitely not the case back in the past. On the other end, as shown above, the cumulative inflows to EM have been unprecedented and much of the recent growth of inflows into EM has been a necessary condition for the growth which has made their fiscal performance positive. The lesson that’s possible to take from the European crisis is that fiscal positions that look healthy can quickly deteriorate once credit flows dry up and growth falters.
So there is space for both views: the story could be structurally bearish or it is already providing a juicy buying opportunity. Just for the sake of exemplifying we report two different ‘sell-side’ arguments supporting different investment recommendations.
“The current exit from EM is more technical than fundamental in nature, though soft EM activity data have certainly contributed and could still accentuate the extent of this sell-off. With the US recovery now on a firmer footing, the risks to EM growth should be contained. With lower leverage levels, EM remains systemically less vulnerable to tighter funding than most DM economies. We would not therefore expect this round of deleveraging to resemble the flight-to-quality and contagion-driven sell-offs of 1998, 2002, and 2008. Instead, as is normally the case in technical sell-offs, we expect improving valuation to counterbalance outflows in the next few months.” (Deutsche Bank, EM Adjusts to Tightening Liquidity, June 13th)
“Our view remains that this correction will extend over the next few months, as it is essentially driven by US monetary policy repricing, a process that has only just started. There is significant nervousness in global emerging markets and volatility has edged up substantially. This means that there is going to be plenty of opportunities to trade the market on a tactical basis. However, the strategic call remains to be bearish. We will change our views only if the Fed turns out to be in absolutely no rush whatsoever to reduce quantitative easing, and if by the same token, the US economy shows some strong signs of back-to-recession mode. In this event, this would resuscitate the generalized hunt for yields. The dollar would weaken, the UST would rally and there would be renewed appetite for high-yielding assets in EM. At this point, our bias is to fade any temporary signs of strength to re-establish bearish positions.” (SociétéGénérale, How to trade the GEM correction, June 13th)
It is obviously a difficult choice, but for the time being we tend to subscribe to the more bearish view, mostly because, as brilliantly put from Jens Nordvig of Nomura, “It is all flow driven, and it is not a move to fade. The catalyst is real (re-rating of global real rates), and the previous EM inflows were big. This could run further. We may be in overshooting territory now versus fundamentals. But it does not matter much in the short-term.” And we think, since past inflows have been so big and
Emerging Markets fundamentals are quite shaky, this might not matter much even on the medium term.
Still it would be unreasonable to just dismiss any level as a good ‘value’ opportunity especially since, while ‘at night all cats are grey’, we need to be reminded that the EM world it is a quite diversified ensemble in terms of fundamentals. A couple of recent papers I have read can be of help in picking up the right apples.
Which EM currencies are the most vulnerable?
Methods and analysis can be very articulated and differ to a great extent. I will present some research notes from major investment houses to give a starting compass in differentiating. For the rest I can only wish good luck to any investment choice…
For Goldman Sachs, vulnerability goes along these axes:
- Ratio of the current account deficit to GDP
- Share of consumption to GDP (countries with large needs for external financing to support a level of national income that is largely geared towards consumption are also those most likely to be severely imbalanced)
- Accumulation of net external liabilities to GDP
Starting point in terms of misaligned asset prices
- Level of real rates (using 1y - 1y forward inflation expectations)
- The degree of FX overvaluation relative to GSDEER (proprietary GS model for ‘fair value’)
Using these parameters they draw some general conclusions. Turkey has a low ranking across all metrics. Brazil has a low ranking on most. The Philippines emerges with a larger number of low rankings than high ones, and there is also evidence of vulnerability for South Africa and Thailand. India is particularly exposed in terms of current account deficit position while Poland and Hungary are vulnerable because of high foreign ownership of their debt. On the other hand, Taiwan, Singapore, Malaysia, Korea and Indonesia rank highly on many counts.
Morgan Stanley uses a somehow different set of four metrics:
- Surges in portfolio flows or ‘hot money’
- ‘Original Sin’ and its new manifestation, i.e. the dramatic increase in foreign holdings of local bonds
- Twin deficits
- Excessive domestic credit, which can cause not only greater reliance on funding but also capital misallocation
Figure 6 shows their findings.
Alessandro Balsotti – July-September 2013 edition