A Random Walk Through Emerging Markets

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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 piƱata.  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. 
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abee crombie
admin
June 5, 2017 at 8:30 PM ×

"Trading EM rates is like getting the whole enchilada rather than just the rice and beans. "

Very much agreed, yet still a novice in the area of EM local bonds. So how does a punter get into the game? Very difficult to trade unless you are at a bank IMO. I just play around with EM Local FX ETF/ CEFs, but you cant really target a country / curve. personally but I'd love to hear some better options.

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Leftback
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June 5, 2017 at 8:53 PM ×

Keep half an eye on Banco Popular situation. Cocos trading at about 50c. Credit defaults, rather than equity losses, are invariably the origin of major dislocations in the global markets and this is getting closer.

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IPA
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June 5, 2017 at 11:59 PM ×

@River and @dfdsfiol, BOC put a bid under CAD, banks bounced as well. I would like to see another 2-3% upside before I look at reshorting. The first, and probably the most profitable leg of this Canadian housing trade is over, imo.

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dfdsfiol
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June 6, 2017 at 1:10 AM ×

I don't think we've even seen the beginning of the Canadian housing debacle. You haven't seen nothing yet. What happens in the near-term I don't know, but next recession its going to be a blood bath. We are 10 years since. How many more years are we going to go on without a recession in the US?

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Shawn
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June 6, 2017 at 2:50 AM ×

@ abee crombie, I think the two significant EM fixed income etf's are EMB (based on the JP Morgan EMBI, the global usd-bond benchmark) and EMLC, which is based on the JP Morgan GBI, the main local bond index. For anything liquid enough to be worth trading, I don't think there are any country-specific ETFs, although there may be something out there if you felt strongly enough about something to hold it long-term.

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abee crombie
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June 6, 2017 at 3:04 PM ×

@Shawn. Yeah i look at those ETFs, there are also a few CEFs which are decently managed EDD/EDF . But sometimes I wanna play a country/curve and its just very difficult. I know brazil has eurodollar type futures, any one able to trade them with a PA?

anyways with all this bitcoin stuff going crazy still (its going even more crazy than I realized, companies are raising $20M dollars in minutes, and has real implications for the whole VC model) I am hoping in a few years you will be able to do carry trades pretty easily via some sort of crypto currency.

https://en.wikipedia.org/wiki/List_of_highest_funded_crowdfunding_projects
Basic attention token, looks interesting. Raised $3M in 30 seconds. WOW

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abee crombie
admin
June 6, 2017 at 3:05 PM ×

sorry, raised $35M in 30 seconds.

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johno
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June 6, 2017 at 5:51 PM ×

There are only so many big moves in G-10 one is going to catch, and if one isn't going to bet the year on just a couple moves, it's important to broaden out to the EM opportunity set, IMO. So, I'm looking forward to your next posts, Shawn.

abee, to trade rates, as far as I know, one needs an ISDA, and for particular currencies (esp. the majors), a clearing account. It's expensive for the counter-party and it's highly regulated, so it's expensive to get setup. The bid/ask for a private client is also way wider than you'd find in rate futures for USD, EUR, GBP, etc., so the trade has got to be really good for it to be worth it. That said, it's important to understand what's going on in the rates and local bond markets to trade EMFX, from a fundamental angle.

Receiving MXN 5Y (or 1Y5Y receiver) seems a decent trade. Banxico probably on hold this year, but next year I'd expect a cutting cycle. 2-2.5% real over 3-3.5% inflation works out to maybe 5.75% target. Happy to hear push back on that, or better expression.


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IPA
admin
June 6, 2017 at 6:37 PM ×

@dfdsfiol, I hear you, just waiting for a bigger retracement first. This being said, all the things you mentioned have been discounted (less deep recession), and we just had a 13-17% selloff in major Canadian banks absent any real system shocks. Again, not disputing your long-term thesis at all.

M is being shot in the woodshed outback, in case anyone is interested. If XRT closes here it would be the lowest close since 6/27/16. While loss prevention is out to catch anyone who dares to steal the retail merchandize it is all about to be thrown out of the front door for free. Check out FRAN, it makes a good case for my ULTA, but I am just going to be quiet bacause it's hard for me to type as I am holding my nose with both hands in order to avoid smelling the urine while pissing against the wind.

I have another retail short idea: LOW. She is pulling back on shoes, clothing, jewelry and hopefully cosmetics, and he will soon do the same on tools, hardware, and home improvement. Price structure resembles Aug of 2016, look out below! Targets: 76.50 74.80 73.20 and 70.40

WTI is hopping again, watch 89ema on 1hr, two closes may just unleash the short covering and send it passed $50 on a hunt stop. This talk about Paris climate accord pull-out by US causing major collateral damage to crude is so silly. The price is in the trading range where players will find any reason to chop and cycle in the box. Paris, Qatar, plain silly...

Gold above 1300 will look for path to 1340 and 1380 to inflict maximum pain. Whatever the reason for the rally, once 1300 is cleared on consecutive daily closes it will be a stampede to cover the shorts, imo. GDX is to follow the path: 25 and 26 are the targets.

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Fresh
admin
June 7, 2017 at 12:35 PM ×

IPA, if you like gold, the best trade I have seen in a long time is buying GDXJ or even a basket of the downweighted stocks. It is unique and unprecedented what they have done here. In effect, they have down weighted most of the small/mid golds by ~70% and added larger cap plays such as IGO, OGC, and NST in Aus. This has equated to smashing out up to 10% of a market cap in the screen in some cases. Purely in a bid to increase capacity of the ETF vehicle as they approached 20% in some individual names. In the meantime they have slaughtered their own NAV, while outflows have also front run the reweight and added to the selling. Short interest has ripped higher in the effected names over the last month so positioning starting to get a bit too cute I think.

It's a bizarre event any way you look at it, but one of the best risk/reward set ups I have ever seen. Need to be long prior to Fri 16th then watch it go over the next month.

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Fresh
admin
June 7, 2017 at 12:43 PM ×

For what it's worth I have bought both GDXJ and WGX in Aus over the last couple of days. WGX trading on 0.65x NAV vs developing peers > 1x. They also have strong production growth over the next 2 years and most are yet to do the work on it. Importantly, has been smacked around the ears by the recent downweight flow!

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abee crombie
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June 7, 2017 at 1:38 PM ×

GDXJ does look interesting, cheers. MM had a similar note on the bloomy

IPA, yeah M is killer, but when you look at XRT, a good 20-30% of the names are still doing well. Lots of dispersion in that group. PCLN not showing any signs of weakness, nor W. Have to watch with these ETFs. I think your retail REIT is a better play. But Mr Market doesnt seem to care. Buy tech and back to the hammock he says.

Not sure if I want to short LOW. I have been too bearish on HD for the past 3 years. Was the easiest housing related trade, much better than XHB or ITB. Still think these guys are in an OK spot and with LOWs cheaper you always have Value guys stepping in at some point (but also there to get squeezed for a trade). But if they disappointed next quarter on the top line then you might be on to something. But I dont have any feel for that right now.

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abee crombie
admin
June 7, 2017 at 1:47 PM ×

Johno, on MXN, I like the trade, though still not sure of political risk at home, even if recent state elections were OK. Not sure if its priced in or not.

I dont have ISDA, so left buying bonds/stocks/FX. I guess if I want to play FX and rates, need to buy longer tenure cash bond. But agree of direction of rates. Way too high now for an economy not doing so well, assuming worst of FX depreciation is over.

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Shawn
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June 7, 2017 at 3:22 PM ×

@johno & abee crombie, I'm positive Mexico rates at large in the context of a broader hedged portfolio as I noted in my post today. I'll get into that more deeply next week. Long story short, i think you're right, Banxico can and will hammer the short-end to stabilize inflation expectations, and I don't see any evidence of second round impact from the current spike in inflation. But they have plenty of space to cut if the economy stagnates (so I think more duration rather than less). Per your point on politics, AMLO risk is probably running a little low at this point and will inevitably spike again before the election, even if he winds up losing or watering down his rhetoric.

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eruditetroll
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June 7, 2017 at 4:48 PM ×

Just to stir the conversation (regarding emerging market fixed income) up a bit, I wonder if someone could respond to point number six in this article?

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CrazyDiamond
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June 8, 2017 at 9:23 AM ×

Great Post Shawn. Having done US and Canadian corps/sovereigns for the last 6 years, I've moved to managing local currency and hard currency African bonds. So more FM than EM, but similar historical trends, similar risks and opportunities. Good to read more on this.

We're working on helping investors access these markets better. Hopefully can share more on that soon....

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June 20, 2017 at 1:56 AM ×

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