EQUITIES

I do not invest in emerging markets. Too many moving parts (earnings, accounting, disclosure, forex, politics,…) with unlimited potential grey and black swans from so many corners. It is almost impossible to correctly value emerging markets and adequately measure risk vs reward. Last 15 years: much volatility (risk) with zero overall growth (reward). Only for traders who can be repeatedly smart (lucky?). Key word is repeatedly. Poor odds for me! North American equity markets provide a large enough playground that I can better understand and value. Despite what they say, diversification is not necessarily risk/return positive.

From time to time, an emerging markets crisis rocks all other markets for a while. The root causes are generally the same: rapid increases in U.S. interest rates and the U.S. dollar.

Jerome Powell explained the links between U.S. monetary policy, the USD and emerging economies and markets in a speech to the Institute of International Finance in October 2017. That was before he became Fed Chairman.

But in a May 7, 2018 speech to an IMF conference, the new Fed Chairman felt the need to tell the world that U.S. monetary policy isn’t the major cause for EM crisis.

There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.

But Powell added these warnings given that Fed policy was for scheduled rate hikes well into 2019:

I do not dismiss the prospective risks emanating from global policy normalization. Some investors and institutions may not be well positioned for a rise in interest rates, even one that markets broadly anticipate.

Risk sentiment will bear close watching as normalization proceeds around the world.

Global policy normalization is central banker current wording for scheduled multi-year rate increases. You have been warned.

What Powell is referring to with “risk sentiment” is the highly sensitive risk-on/risk-off trigger on emerging debt and equity markets that effectively dictates capital flows so important for dollar-indebted EM countries and companies.

In previous EM crisis, developed world banks were the lenders to EM countries. This time around, the lenders are mainly bond investors and the borrowers a mix of EM corporates, small to very large, and, to a lesser extent, sovereigns.

In previous crisis, the epicenter was relatively limited to one or a few countries like Mexico in 1982, Thailand and Malaysia in 1997. Redirected capital flows made the crisis global but the economic damages were limited in time and scope. This time around, the visible problems are in Turkey, Argentina and Venezuela but heavily dollar-indebted corporations, spread across the world, are silently suffering the pain of being slowly strangled but rising rates and the strong USD. Eventually, the strangled groundhogs will suddenly emerge from their increasingly uncomfortable undergrounds in need of financial air or simply declare bankruptcy.

In previous crisis, the risk-off trades were in equities and the debt instruments of specific countries and banks. This time around, the risk-off trades will combine both equities and EM bond funds, creating a lot more additional pressures on the weak currencies and further boosting the USD, amplifying the problem in the process. ETF investors will want to rush to the exits, only to find very narrow exit doors with few buyers on the other side? This time around, the next EM crisis will also be a liquidity crisis that will likely impact all asset classes in both emerging and developed markets.

Data from the Institute of International Finance show that EM ex-China debt has almost doubled to $27T since 2007 while China’s has been multiplied 6 times to $36T.

Corporate borrowings have ballooned across the world while central banks drove interest rates through the floor.

U.S. interest rates are now going in the wrong way for these unprepared borrowers. The Fed has set the path straight up for short term rates, from nearly zero in 2015 to their current 1.75% on their way to 2.9% at the end of 2019 per the most recent Fed dot plot. Longer term rates are feeling the upward pressure while also lifted by rising inflation and inflation expectations. Ten-year Treasury yields bottomed in 2016 at 1.4% and have since gone up 170 bps even though still offering a historically low 0.6% real yield.

With more than $3T in EM debt maturing between now and the end of 2019, refinancing will necessarily cost between 300 and 500 bps more on fixed rate debt alone, a whopping $120 billion jump in annual interest costs on fixed rate debt. Some 50% will be absorbed by the non-financial corporate sector.

This, without taking into account the damage inflicted by the rising USD.

Foreign investors have increasingly bought domestic-currency bonds, seeking both credit and currency gains. If investor appetite for EM risk reverses, issuers may face refinancing challenges even in their home markets, while capital outflows could put pressure on exchange rates or foreign exchange reserves. (Fitch)

Add rising oil prices and you get something close to a perfect storm. It will likely start in the EM world but interest rates and oil prices are rising across the developed world as well where non-financial corporates are also highly indebted.

Groundhog days ahead! Watch your step.