Markets are about discounting the future. Analysis, however, starts by looking backward. When forming views for the first time we tend to get out the rear view mirror, focus on the parallel that pops most readily to mind, and then—at least initially—overstate the linkage. Most by now will recognize this as the availabity heuristic; it’s also why there is always a 1929 market somewhere.
Emerging markets are in a serious bear market, and have been for a few years (2011 for equities, since the 2013 Taper Tantrum for local currency fixed income). And old hands in emerging markets are seeing an embarrassment of riches in the rear view mirror. Some are even drooling for the kind of blood-on-the-street opportunities on which so many EM types have made their (our) bones.
But there are good reasons to believe emerging markets this time around are not going to experience the kind of crashes, deep recessions, and defaults that they are famous for. Yes, I am saying it’s different this time.
First, the negative. We had a bull market and massive inflows for some 12 years, in which higher prices flattered our perception of the fundamentals. Now we’re clearly on the downside, when investors turn more bearish as outflows intensify and price action worsens. Self-reinforcing markets are not pretty, but it’s how they work.
Moreover, the conditions necessary to begin to attract flows back to the asset class just aren’t there. Yes, some were tempted at the beginning of the year to make the contrarian call in the beat up asset class, but those inflows are already part of today’s outflows. For inflows to be
sustained, some combination of three things needs to work in your favor:
- An end to US interest rate hikes. We don’t actually have to see the end of the hiking cycle, but we have to at least be able to form a confident guess about it, in terms of both time and terminal rate. We need to have a view on what the end looks like. For now, we are still trying to figure out what the beginning looks like.
- A weakening US dollar. Returns in EM equities and local fixed income are overwhelmingly driven by currencies. The dollar is in a bull market. Even if it weren’t to go too much further or faster, big money allocators will be loath to step in front of it until they are beat over the head with signs that it has reversed.
- A big positive growth differential. Investors take on extra risk when they get their passports stamped. Property rights, rule of law, and corporate transparency are sketchier propositions in EM. The prospect of a significant growth differential relative to the home basket needs to be there to compensate for these risks. As far as I can see, it’s not even on the horizon. EM countries, inter alia, still have a lot of private sector credit overhang to chew through.
That’s a pretty bearish backdrop. But there are five important reasons why it is not likely to translate into an EM crash, replete with old-fashioned contagion, defaults, and recessions.
- Most emerging markets now have flexible exchange rates and much higher levels of reserves relative to historical norms. The most spectacular EM crises took place inside the pressure cooker of fixed exchange rate regimes. The imbalances built and built and built until they gave way in spectacular fashion, shocking investors and forcing liquidations. Today, FX moves are continuous, and the ample reserves can be used to circuit break and ensure continuous pricing, since they are no longer needed to defend a peg.
- No more Original Sin. EM sovereigns used to borrow in dollars, but collect revenue mostly in local currency. This mismatch was labeled (I think by @ricardo_hausman) as the Original Sin. The rapid development of local markets (see below) has allowed sovereigns to shift the overwhelming majority of their funding to local currency instruments, making debt service easier and creditworthiness scares less likely under a wider range of potential FX and growth outcomes.
- Deeper local markets. A positive aspect of the global financialization over the past 10 years is the development of pension systems, asset managers and insurers domiciled and/or denominated in EM. Buyers of the first resort with steady inflows create a shock absorber when tourists rush for the exits. These entities either didn’t exist or weren’t major players in EM episodes past.
- Short dollars, not short dollar gamma. EM corporates have issued a large amount of dollar denominated debt over the past 7 years. This makes them basically short dollars. Some of them will not have the dollar revenue to cover, and using local currency revenues at depreciated exchange rates is very expensive. This will be a problem for EM. However, in the run up to the Financial Crisis, EM corporates were heavily speculating on continued USD depreciation by selling dollar calls to finance dollar puts. When these positions started to unwind, the negative gamma led to explosive price action, as the corporate positions grew in size as they moved against them. Given the absence of these kinds of positions today, currency moves are likely to be more continuous and manageable.
- We have already seen a lot of outflows. We are a number of years into the bear market, and while my bias is still bearish, one has to recognize that the bear call becomes riskier the further it runs. The odds of the necessary conditions falling into place become more likely, not less likely, with each passing day.
In sum, the bad news is that the fundamentals and positioning in emerging markets are still not favorable enough to support strategic allocations to the asset class—even though sentiment is already quite negative (Just look at the discount to NAV on ticker EDD) . The good news, however, is that even though we have a tendency to overstate parallels to the past, over time we progressively refine our analysis, see the differences, and come to more nuanced views. Bad does not equal crash.