A Random Walk Through Emerging Markets

Welcome to the first edition of MM’s “EM Corner.”  TMM certainly swam in EM waters from time to time, and we approach markets from the same perspective: global trends have a trickle down effect that impacts assets throughout the world. While I focus on EM assets, it is paramount that I have a firm grasp on global macro. If you’re looking for the latest technical analysis on EEM, sorry, you’ll have to go somewhere else.

One of the great metaphors of financial markets was coined by the Venezuelan economist Ricardo Hausmann: the “original sin” of emerging markets. Before there were developed EM bond markets, all EM governments relied on bank loans from US and European banks. These loans were made largely in dollars, but the revenues of the country are in the local currency. As the local currency depreciated, the dollar liabilities became more expensive to pay back, leading to a vicious spiral. This is what drove the boom-bust cycle of EM, usually ending in default, revolution, or ex-Citibank bankers absconding from Manhattan under cover of darkness.   

That boom-bust cycle still exists, but market developments have changed the dynamics.  One trend I have been droning on about for years is emerging market governments’ move away from dollar-denominated debt towards locally-denominated debt, which puts more pressure on FX as the relief valve or adjustment mechanism. More about that later in the week.

How much of EM is in the tradable macro universe?

There are three big asset classes in what we’ll call “EM Macro”: 1) Equities, via some ETF like EEM, or ETFs based on country-specific sub-indices, 2) FX, which is going to be done via spot or forward trades in currencies like MXN, BRL, TRY, ZAR or CNY, and 3) Fixed income, which has a smorgasbord of potential goldmines or widowmakers: dollar bonds, local currency bonds and swaps.

I largely stick to FX and fixed income. People like to talk about FX, because there’s a number you can get your hands around. You can build a fundamental case for the currency of your choice. There are few markets out there that lend themselves better to charting and technical analysis. And in most emerging market countries, there is a history of huge devaluations of the local currency seared into the collective memory. Most locals will have some idea, maybe even a very exact one, of how much their local savings is worth in dollar terms, unless of course, they are saving in dollars already because they became conditioned to their government treating the currency like a piñata.  Everybody has skin in the game, and everyone has an opinion.  You can recognize the watercooler talk.

“Where did you buy usd/zar?”

“I got short at 12.50, riding the wave. Commodities are strong and the Fed’s on hold, man.”

“What do you think of usd/brl here?”

“I’d love to be long but the carry is a killer.”

“Has anyone seen Bill? Haven’t seen him in a couple of weeks.”

“He’s gone. usd/mxn.”

Combine that easy access with big moves and huge flows, and you can see why a traders love a good FX story.   

I generally see better opportunities in fixed income. The correlation between FX, inflation and local interest rates cannot be overstated. Trading EM rates is like getting the whole enchilada rather than just the rice and beans. Gauging inflation is key--many EM central banks explicitly target inflation for monetary policy decisions, and bondholders face inflation with all the courage of a bunch of chickens dropped into a dog pound. There’s also credit: some countries borrow cheaply, like Germany, and some borrow at usurious rates from Goldman Sachs, with grave human consequences, like Venezuela. And countries have options about where and how they issue. There are vast pools of buyers from real money, hedge funds, SWFs, local pension funds, local mutual funds and central banks. So understanding supply and demand is vital.  

In the past several years, EM has generated some big macro opportunities. There was the Chinese-reflation story of 2010-2012, when Beijing decided to throw open the credit channel to keep the factories humming. This drove demand for EM-intensive raw materials, and in combination with the Fed’s QE printing press running full steam, it was all systems go for EM.  Huge inflows cascaded into EM and caused many currencies to re-appreciate to or beyond pre-crisis levels.

Later, there was the great unwind and outflows of 2014-2016. The combination of slowing Chinese industrial demand and increasing inventories crushed commodity prices. That, combined with the Fed finally starting to hike rates in late 2015, spurred a huge rally in the dollar. As we have seen so many times in so many markets, locals, hedge funds and real money fled EM like their hair was on fire. Big depreciations in local currencies drove a spike in inflation, and falling growth rates hammered fiscal accounts. This combo platter caused a dramatic increase in real and nominal interest rates.

In early/mid-2016, there was a huge buying opportunity in EM as valuations hit rock bottom, commodity prices bounced off the lows and many countries made progress in plugging holes in their current accounts and/or fiscal balances.  So you can see how just in the past five years there have been a few chances to make a ton of money in EM, just by considering the macro implications of what is going on in the world, especially in China and G3 monetary policy.

The current market is quite supportive of EM. Global demand has picked up. Commodities have stabilized, and the dollar is chopping around, with the potential to weaken if we get more lousy data like we did on Friday. Historically low levels of vol in risky assets is pushing foreigners into EM carry trades, a trend that usually tends to go on longer than most people think, even if it will again end in a stampede for a tiny exit door. I don’t see a catalyst for this to change in the short term, and given the still low DM yields and structural improvements in some significant EM economies, there is room to run in EM at large.

Stay tuned to MM later this week for a discussion of the political fireworks and reform agenda in Brazil.

Shawn
TeamMacroMan@gmail.com
@EMInflationista