Tuesday, May 27, 2008

Old School

Old school. To some, it means one of those Will Ferrell film vehicles, with all that that entails. To others, it means a certain bygone era in hip-hop music...usually when spelled "old skool." And for market graybeards like Macro Man, the phrase "old school" conjures up something else entirely; the image of an "old school" emerging market crisis.

For most market punters under the age of 30, crisis is something that affects the credit guys and not much else. Sure, the subprime crisis has eliminated any semblance of a bid for certain categories of credit instruments, but in other areas you can still get stuff done, even if bid/ask spreads widen a bit. And as for emerging markets, hey- they're the best game in town! Haven't you heard of decoupling? Well, the nature of the game might be changing. For in the past week or two, a situation has been brewing in emerging Asia that reminds your author of the EM blow-ups of the 1990's.

For the last few years, Vietnam has been something of a frontier market darling. With a large population willing to work for low wages, Vietnam has begun to erode Chinese market share in certain low-end industries such as textiles. And as Chinese wage costs continue to rise, Vietnam was supposed to be in the catbird seat to win market share and embark on its own bout of explosive growth. This in turn spawned such products as the Vietnam Opportunity Fund, a London listed closed-end fund investing in Vietnamese shares. Hell, even Macro Man threw a little bit of money into it.

Recently, however, the story's gone badly wrong. Terms of trade shocks have sent the external accounts spiralling badly out of control; Deutsche Bank forecasts a trade deficit of 25% of GDP this year. Overnight, inflation printed 25.2% y/y....ouch! Meanwhile, the formerly safe, attractive fixed income/curreny market has completely blown up. The chart below shows the USD/VND fixing rate in Singapore. There was an early warning sign in March, when the official State Bank fixing rate rose from 15800 to 16100. Recently, however, the offshore markt has been fixing markedly higher than the official rate. Today, the market has imploded. While the State Bank fixing rate was 16216, the Singapore fix was above 17000. This morning, one month VND was traded at 18900. For anyone involved with VND who expected a 0.50% annualized volatility, which is the vol of the official fix, this must come as a rather nasty shock. If you're keeping track at home, that one month trade implied an offshore annualized dong interest rate in excess of 100%.
The pain hasn't been confined to uber-frontier markets, either. While the Philippines isn't exactly the most liquid markte in the world, it has definitely gone a bit mainstream over the past few years. And while the pain there isn't as pronounced as in Vietnam, it's still pretty unpleasant for trapped longs. Since the end of February, USD/PHP has risen 8.7%- ouch! This was not altogether unforeseeable- Macro Man went long USD/PHP in mid April on the theory that rising food and energy prices would have a deleterious impact on the balance of payments.. Still, liquidity has completely dried up over the past week, and NDF markets were pricing offshore PHP interest rates at 30% this morning, which is a tad higher than the onshore rate of 6.37%.
This meltdown in low-quality Asia has yet to show meaningful signs of contagion. And we can be pretty sure that positions there are exponentially smaller than in credit instruments linked to US subprime mortgages. But just as pain in those turds were the canary in the coal mine for last summer's volatility, could the distress in frontier Asia suggest more pain ins tore for risk assets? Macro Man is, on balance, short "risk"; given what he sees in Asia, he's happy with the position.

One place that should be immune from external market shocks is China, where data released overnight revealed a record monthly increase in SAFE's FX reserves in April. Early in that month, USD/CNY ground to a halt, going essentially nowhere for six weeks and squeezing out the offshore specs. Quelle coincidence....


vlade said...

What are anyone's thoughts about the EU new markets/Latin Am/Russia? Will they decouple, of will they tank too?
My feeling at the moment is that they will tank, but probably not as much as Asia EM, and less than US/UK too. Somewhere in line with Germany I'd say, althought the risk there is the (relatively) low liquidity in currencies.

Anonymous said...

Thank you, how does record fx inflows translate into a sideways cny? I am assuming that the relentless march of EUR/USD from 1.55 to 1.60 for the first 3 weeks of April was the result? Thank you too for pointing out the PHP issues, I was unaware of them. The PHP has however on a longer term scale been reacting off of a multi-year rally from north of 55...how does that fit into the current context of bop/inflation, etc?

Macro Man said...

Anon, my presumption is that the underlying pressure for the RMB to appreciate remained intact (admittedly largely driven by capital flows) , but that SAFE stopped it in its tracks by buying dollars with what some might call reckless abandon.

PHP rally has, I believe, been driven by improved politics and large remittances. My short PHP position was taken on the view that it had come a long way without challenging any coat-tailing traders/fund managrs, and that the BoP was likely to take a hit from adverse terms of trade shock.

How the commodity boom plays out will ultimately dictate how far this correction goes and how long it lasts.

Anonymous said...

Yes, when the music stops...thanks for your explanation. How does the European curve play out if inflation pressures remain? its back to levels it was trading at when the ECB was actively hiking rates, and historically withing a few bp's of significant support...can the stagflation grow and long rates decline while short rates go nowhere always vulnerable to the Weber, etal?

"Cassandra" said...

MM - Old School is also a fantastic novel by Tobias Wolff about a bursary student (jewish poor outsider) at an eastern boarding school (Andover?) that's a celebration of literature, poetry, and a more innocent time now-gone. It contains one of the finest and most poignant parodies of Ayn Rand that will have everyone (except Rand 's most fervent disciples and acolytes) rolling on the floor with laughter. It is even better than Bob The Angry FLower's Atlas Shrugged 1- Month Later

Richard said...

From what I've heard, a goodly portion of real estate speculation in China is financed with borrowed US$. Is there any connection between weakening China to US export business and this short position in borrowed dollars?

There is also quite a lot of internal shocks in China, AKA earthquakes, which will consume money and bring about inefficiencies, not to mention the human cost.

Anonymous said...

I think Macroman is correct in his assessment that the ECB won't be lowering interest rates any time soon. The "old" EU markets seem on the whole to be chugging along nicely, and despite the rumors it would appear European banking is not in as bad a shape as across the Atlantic. That said, new EU markets are in for a rough ride, with recessions likely in a number of those countries.

Consider the Baltic trio, wild years with high growth rates but also out of control wage hikes, inflation, housing and current account deficits. That party came to an abrupt end, with this year's Q1 showing flat growth and Q2 likely to show a recession in progress.

Anonymous said...

Care to guess where the bottom is for USDMXN?