5th February 2014
There has been a flood of fund manager views and economists’ notes on what exactly is happening in emerging markets. But one of the more interesting commentaries of the last few days comes from Axa’s Mark Tinker, head of Axa Framlington Asia. It was published last Friday so things may have moved on a little but we think that most of his ‘market thinking’ still applies.
His views are very technical. But first we are going to pull out a few of the highlights. Among other things he suggests that hedge funds are moving to hit the losers in emerging markets.
He also notes that primarily the ‘hot money’ in emerging markets has been in bonds not in equities. He says a lot of leveraged money has been chasing EM high yield particularly given the troubles in Europe.
The outline of what is happening and how it may manifest itself is included below. But crucially he does not believe that China is quite the problem that has been described and he questions the motives of those who are suggesting it is 2008 all over again.
Anyway as we say, it is one for the seasoned investor who likes the technical side of things, but if you, and you want what reads like a credible analysis of what may be happening, it is well worth a read below.
“I am neither a China nor an emerging market ‘bull’ per se, rather I believe that recent events in China are being used as a ‘casus belli’ by macro funds and there is thus a risk that investors confuse tail risk with central case scenarios. The year of the horse is apparently always difficult when it is characterised as it is this year by wood and fire according to a suitably gloomy front page of the South China Morning post, who also tell us that apparently in April Mars, Jupiter, Uranus and Pluto will form a ‘cardinal cross’, which is apparently a bad thing. Such articles become more prominent when ‘bad news’ is in the headlines. Sentiment is very fickle and it is important to distinguish between market behaviour and the underlying economics. The former can definitely affect the latter, but the common danger is to let observing market behaviour lead us to believe that the market is somehow predicting or identifying different fundamentals and therefore to change our inputs.
“One thing we know is that macro hedge funds tend to hunt in packs and work by ratcheting up the noise to make their trades ‘work’. Thus at the beginning of the year the macro traders tried to push through a mean reversion strategy; the losers from last year-started to perform better and the winners began to sell off. This prompted a combination of short covering and profit taking, effectively flattening positions against a benchmark. However, there was no real appetite to buy ‘bad’ assets beyond that, nor sell good ones. The central idea of these trading books is as much about playing the man rather than the ball and thus with no follow on selling or buying on the mean reversion trade, the tactic then switched to momentum trading (yes it really can work as simply as this) with a move to hit the losers from last year hard to see who could be shaken free. This is much more successful in currency and fixed income markets where leverage is involved and the former in particular can get very hyperbolic. It is important to remember that for an FX trader a ‘big figure’ is the second decimal place, thus the 1% move in Mexican peso/yen, cited in an article by Bloomberg this week as being a ‘disaster’ for some traders really is. For them, not us. The big shock of course was the Argentinian peso, allowed to devalue by a government that had been fighting economic reality so the talk of crashes, meltdowns, debacles and routs in emerging markets is really a currency issue. It can of course become an economic issue, but seldom really does. After all the bid offer spread on a tourist FX rate is usually over 5%.
“It is also very important to remember that the hot money in emerging markets (EM) has been in EM bond funds, not equities. EM equities had been on a bull run from 2003 onwards, including being a heavy overweight for a number of global funds, but the rush for EM bonds has been a recent phenomenon, with a lot of leveraged money chasing the high yield, particularly with the troubles in peripheral Europe.
“The key to the enthusiasm appeared to be a curious belief that not only would you receive the high yield, but you would also get a currency gain – after all the $ was going down forever (which is why many on the same trade also bought gold). This of course was defying economic gravity but became a self-fulfilling momentum trade in the short term, driven by exactly the sort of ‘market is going up therefore fundamentals must be good’ type logic which is currently operating in reverse. At the time, the yields on emerging market debt were high in nominal, but not in real terms and the economics is such that the exchange rate ultimately moves to equalise the internal and external purchasing power of the currency; i.e. higher inflation leads to depreciation, not appreciation. Hence there is no free lunch – you can’t have high yield and an exchange rate gain. Except as a trade that is. In the short term it can become self-fulfilling, especially if you make a lot of noise along the way to drag more liquidity in and generate momentum (yes, them again). Currency inflows chasing yield at the long end push up the exchange rate and flattens the yield curve and, usually, trigger a cut in short rates pushing bond prices even higher. Everybody appears to win, the economy booms, asset prices rise, governments become popular. At the peak last year the spread between 5 year Spanish bonds, which everyone hated because of course the economy was apparently going to collapse, and Brazilian bonds, which everybody loved because of, err China, was a little over 200bps. Now of course that everybody has turned the fundamentals 180 degrees the spread is over 1000bps
“Usually the trigger is that inflation starts to rise and central banks start to raise interest rates causing the whole process to reverse. Perversely in the short term this can lead to a further rally in the exchange rate as flows come into the short end. Turkey, notably, continued to cut short rates even as inflation was picking up because it didn’t want the currency to go up any further, which is actually one of the reasons that they have more problems right now. Ultimately though it is the exchange rate that signals the classic emerging market boom and bust. The same liquidity squeeze that drives it higher becomes a panic that then drives it lower, hence the old adage that an emerging market is defined as one you can’t emerge from when you need to.
“Of course it is never quite the same each time, the source of the capital varies and the channel through which it is funnelled is different, but the end result is usually the same. This time the channel was emerging market debt, sovereign and corporate and with a new(ish) twist this time that there was local currency as well as $ denominated debt. This was seen as a good thing for borrowers since traditionally when the exchange rate momentum switches from positive to negative, emerging market countries run into trouble as their debt servicing costs explode and rolling the debt becomes hugely expensive. It is indeed good for the borrower, but clearly not good for the lender, as I have said before (quoting Crédit Lyonnais Securities Asia strategist Russell Napier) that it is fine to lend to somebody, but not in a currency that they control. Such was the enthusiasm for the perceived currency gain however that demand for local currency EM debt exploded and not only were the bonds bought, but in many cases with leverage thrown in as well. Naturally neither the currency nor the leverage was regarded as a risk since we all know that the only sources of risk are tracking error and volatility, right?
“Thus we have a classic bubble caused by the insanity of risk modelling. EM local currency bonds were classified as lower risk than developed market equity and other ‘risk assets’, particularly if you further reduced your ‘risk’ by buying the benchmark. However, the EM bond market is heavily weighted in the so called fragile five of current account deficit countries for obvious reasons; they have a current account deficit therefore they have a capital account surplus and to fund the capital account surplus they have large amounts of debt! This is an inherent problem with bond benchmarks compared to equity ones; while we are not necessarily happy with the notion of having to hold 10 times as much of a company just because it has a 10 times larger market capitalisation on some spurious idea that it somehow ‘reduces our risk’ the situation in bonds is even worse, the weighting in a bond benchmark tends to be to the company or country with the most debt. This can work very well for the borrower, but not for the lender, a capital market version of the old adage that if you owe the bank $10,000 you have a problem but if you owe them $1m they have the problem. Moreover the nature of the index also encourages contagion, a sell-off in Turkish bonds triggers a drop in the index dragging Brazilian bonds etc with it. This is exaggerated by a lack of liquidity in many of the underlying bonds (not regarded as a risk either by most risk models).
“The move to tapering triggered the first round of selling in EM bonds, currencies and equities as the trade was deleveraged. As is often the case, ‘risk’ assets get hit because they are the only ones with any liquidity. This then is the trade of last year and the fundamentals that exist mean that the macro traders are trying to push again. The mean reversion trade in January when the fragile five rallied didn’t mean their fundamentals had improved and those that bought on the basis they had will probably now be selling. However the good companies and countries have not seen a sudden deterioration in fundamentals just because the momentum trade is back on. Indeed we might argue that the sharp drop in say the Indonesian Rupiah last year has already started to bring about an improvement in fundamentals for a number of companies.
“I said at the beginning of the year that we saw value in EM equities but the thing holding them back was negative price momentum – a mirror image of the situation in 2010 when the only thing holding them up was positive price momentum. Thus the value trade was for 2014, but not necessarily for Q1. But (finally) to China. I maintain the view that there are massive structural changes going on in China and we need to recognise that the state effectively owns almost all of the liabilities but also all of the assets that go with them. There might appear to be a Western style division of assets and liabilities between central and local government, state owned enterprises and banks, but in reality it is all fungible. Looking at debt to GDP is dangerous at the best of times (it is after all a stock versus a flow) and as I have noted in recent weeks Chinese local government debt has actually grown less than assets. This is not to say the money has been spent wisely – on a weighted average cost of capital (WACC) versus return on invested capital (ROIC) basis it almost certainly hasn’t – but then again most western government debt goes straight into current expenditure so there are no assets at all. This is but one of many reasons why I am dubious about the widely quoted Reinhart and Rogoff study that appears to predict economies behaviour from debt to GDP ratios.
“The existence of assets is important for China’s restructuring as the government can, and will, package assets and liabilities together and re-assign them to the ‘correct’ part of the economy. Local government has all the debt because it was required to do 85% of the spending with only 50% of the income. That has been recognised and stopped. Local government officials will no longer be rewarded on GDP alone, the balance sheet will be looked at. Just like managers of dot com companies targeting sales or even ‘eyeballs’, if you change the incentives you change the behaviour. We have become obsessed with China real GDP growth and it has become talismanic to ‘forecast’ 7% or 8% or even 6% from China as a way of declaring whether you are a bull or a bear on the global economy. From a policy perspective this is largely irrelevant – the government has stopped targeting GDP – and from an equity perspective we need to know (a) what is the nominal growth figure (an amazing number of people appear to translate real GDP growth into nominal sales) and (b) recognise that the base effect is such that 12% nominal GDP growth today adds the same amount of total demand as required 22% 5 years ago. Incidentally that additional demand would amount to $1trn extra. The recent rapid rise in local government debt has actually been recognising contingent liabilities, not more borrowing and as such there has already been a significant slowdown in infrastructure spending. It is not just about to happen. Indeed, part of the restructuring will mean that the private sector and central government will play a greater role in infrastructure.
“The worrying thing to be honest is the echo chamber effect whereby noise markets have managed to move many so called ‘strategists’ to change fundamental forecasts. ” China remains my main concern” translates into ” I am pretending that I have been talking about this all along and I will now peg my research around a sub 7% GDP forecast”. This happened most notably in 1998 after the Long-Term Capital Management crisis, but sadly happens a lot. We also now hear about how cracking down on corruption is slowing growth and how the Trust company issue is just ‘like 2008’ (check the vested interest on that quote). On the latter, it definitely isn’t, this is a company that went bust two years ago and the authorities have been working out how to balance ‘moral hazard’ against causing a run on the shadow banking system. This element is however like 2008, where a sudden burst of moral righteousness from regulators, heavily encouraged by those long so called ‘risk free assets’ led to fire sales across other asset markets to prevent a recurrence of ‘moral hazard’. Indeed the whole point of QE1 was that the ‘health and safety’ approach as the stable door was bolted made matters far worse for equity markets than was necessary as banks were forced to sell assets (moral hazard) and no-one was allowed to buy except the Fed. Fortunately, the Chinese authorities are not in thrall to the self-interest of the bond vigilantes in the west and are able to balance issues of moral hazard with issues of financial stability.
“There will certainly be losers as China restructures and one factor that has been raised in recent weeks is the round tripping driving foreign direct investment (FDI) into China. The anti-corruption meme has this being choked off – and thus lower GDP etc, but to my view misses the point. A lot of the FDI that comes out of China and then goes back in via Hong Kong is akin to the relationship between Cyprus and Russia. Legitimate money comes out and is recycled back as FDI since it has greater ‘protection’ from confiscation in that format. The real risk – which no-one is talking about- is the extent to which Hong Kong based banks are leveraging that flow up. So while some emerging markets continue to struggle, others are doing well and citing the Chinese financial system as a worry is to be led by the wolf pack. China has massive structural issues for sure, and is addressing them. Winners will become losers and vice versa, but the next liquidity crisis will not come from here.”