Submerging Markets: A Hedgeye Exclusive Presentation
Hedgeye Senior Analyst Darius Dale presented an exhaustive report in an institutional conference call today. “Emerging Market Crises: Identifying, Contextualizing and Navigating Key Risks in the Next Cycle” drew an enthusiastic response from our global investor client base, many of whom run “long-only” mutual funds, investment vehicles that are contractually required to always be fully invested, owning a portfolio of stocks drawn from pre-determined market or geographical sectors. These long-only investors are often among the first to suffer when there is uncertainty in the marketplace. Put yourself in the position of a long-only manager when volatility rocks the boat, all you can do is hold on for dear life and hope the storm passes. In times like these, Hedgeye’s Macro work becomes critical to plotting a course through turbulent waters.
Emerging Markets – What Are The Risks?
Perhaps the overarching risk in EM investing is the shift in attitude that leads investors, first to chase investments they would normally shun, then to suddenly shun investments they recently adored. Markets reflect mass perceptions, and when the mass of investors fear a further decline in formerly-stable markets – as occurred in the US markets in the depths of the financial crisis – they seek refuge in hopeful markets. This may not appear highly intellectual or disciplined – in fact, it’s not. But it is the way many investors behave. “Many” investors becomes a statistic, and a string of statistics establishes a trend. Before you know it, the “smart” money identifies the trend and hops on the bandwagon.
In short, much of what we have seen in major global moves in asset prices and stock markets has been the result of waves of panic sweeping across large swathes of the investment community.
For this you got an Ivy League MBA?
There’s a critical point to keep in mind when assessing risks in global markets. There are huge pockets of vulnerability across the EM space, but exposure to the possibility of a crisis does not guarantee that there will be a crisis. As a 2010 IMF report on emerging market crises states, “Crises require some triggering event.” What we shall call “Dale’s Corollary” is the critical observation that Crises tend to start when investors apply developed market rigor to analyzing emerging markets.
It’s impossible to put too much emphasis on this point. “Hot Money” is driven by the hunt for yield. In global terms this translates into investors seeking opportunity in foreign markets – what’s known as Private Capital Flows.
As interest rates on US Treasuries declined, and as investment returns dropped across the developed world in the aftermath of the financial crisis, portfolio managers and investment analysts gladly applied different standards to analyzing the Emerging Economies, leading to a global arc of cross-border investment driven by a perception of strong commodity demand. The stark message here is that – as Hedgeye’s Macro team has been saying – maybe it was all just the Dollar all along. As Hedgeye CEO Keith McCullough frequently observes: “If you get the Dollar right, you’ll get a lot of other things right.” Dale’s analysis indicates the notion of global commodity demand may be a fantasy. The twin sibling of the chimera of perpetually-increasing house prices that drove the US economy up, up, up… over the tippy-top and into Mr. Greenspan’s executive toilet.
Four Pillars of EM Wisdom
Dale’s presentation targets a complex set of risks in emerging markets and points to drivers of EM vulnerability.
For starters, EM stock markets are largely tied to local commodities, and Dale measures levels of beta market volatility associated with this commodity exposure. Continued unwinding of the global commodity bubble could be a very powerful tail wagging such dogs as Russia (70% volatility exposure to commodity prices), and Brazil (43%).
Dale then presents the “Hedgeye Macro Emerging Market Crisis Risk Index,” constructed on four “Pillars,” each measuring ten key economic indicators, including:
- Pillar I: External Sector – Currency exposure, including exchange rate and foreign currency reserves on hand; the costs of foreign trade, including commodities exposure; and the costs of short-term debt.
- Pillar II: Fiscal Policy – Sovereign debt; tax policy.
- Pillar III: Financial Sector – Bank capital adequacy; cash and cash equivalents in the marketplace; real rates of interest; stock market.
- Pillar IV: Political and Regulatory Risk – Ease of doing business; enforceability of contracts; unemployment; measures of inequality.
Taking previous EM crises as a guide, Dale’s work applied this rigorous analysis to 29 EM countries, as represented primarily in the 21-nation MSCI Emerging Markets Index. Ranking these nations from lowest to highest risk, Dale found different Pillars, unsurprisingly, had different weights.
A House of BRICS
We’ll use the BRICS (Brazil, Russia, India, China and South Africa) to demonstrate how Dale’s complex analysis presents these risks. It looks like the third Little Piggy may finally be out of luck – not because the wolf is any stronger, but Dale has found a design flaw in the BRICS. Dale’s Pillars measure risk across the 29-nation sample, with countries ranked by how many standard deviations they fall either above or below the average for those metrics.
In Pillar I, Balance of Payments and Currency Risk, the high-risk BRICS countries are South Africa, Brazil and Russia, while India and China fall well below the mean.
Pillar II, Fiscal Sustainability Risk, sees Russia and China as rather safe, with South Africa only marginally safer than the average. India and Brazil, however, ranked as the third and second most risky on this metric, only topped by Egypt.
Pillar III, Financial Crisis Risk, ranks Brazil and Russia at below average risk, but the More Risk side of the chart features India and South Africa, and is topped by China, which comes out a whopping two standard deviations above the norm of the 29-nation sample.
Pillar IV, Political and Regulatory Risk, is led by India (1.8 standard deviations above average), followed by South Africa and Brazil, while Russia and China are relatively lower risk on those metrics.
Finally, three of the BRICS nations are among the top 4 for Aggregate Risk: India is highest aggregate risk, while South Africa and Brazil are at third and fourth places – the second slot is occupied by Egypt, which we think says rather a lot about The Company You Keep. Dale singles out India, Brazil and South Africa as “outliers,” meaning they are “more than averagely more than average” risky.
But wait – there’s more!
The Elephant In The Emerging Room
Need we say more? All right, then we will.
China occupies a dominant position in the global marketplace – and in most investors’ minds. Dale devoted an entire second half of his presentation to the question “Will China Blow?” (Spoiler alert: the answer is “We have no idea, but we have some important observations that can tell you what to watch for.”)
“China sticks out like a sore thumb on the Hedgeye Emerging Market Financial Crisis Index,” says Dale. And, while we remind you that Vulnerability does not mean a crisis is certain, it’s one heck of a wake-up call.
How often have you heard stock market pundits enthusiastic about the bottomless well of Chinese demand? “There’s over a billion of ‘em!” they would chortle. “That’s a lot of cell phones! (TV sets, automobiles, athletic shoes, personal care products… or whatever it is you’re touting…)”
Says Dale’s analysis, “Oops…!”
A number of factors point to a dramatic shrinking of Chinese demand:
- Financial repression has left little-to-no place for Chinese savers to put their money.
- Artificially low prices of basic inputs such as water, gas and labor have allowed state-sponsored enterprises to fuel systematic over-investment – despite being much less profitable than private businesses.
- Over-investment creates excess capacity throughout the economy, leading to potential maturity mismatches and nonperforming loans – on and off bank balance sheets
- … China’s expansion of credit is greater than any expansion in any “bubble” economy in recent decades. By a lot.
Chinese savers have no place to get what used to be a normal rate of return on their hard-earned money (sounds like your money market account, doesn’t it?) and have taken to investing in risky off-book trusts and wealth management products structured by Chinese banks. These vehicles operate like blind pools, investing deposits in high-yield projects. China’s own minister of finance has publicly called these trusts “Ponzi Schemes.”
Other potentially massive risks include regional funding shortfalls. Local governments are not allowed to issue their own debt, and so they rely on land sales to plug funding gaps. Some of these sales are of disputed property, which may lead to social unrest as China’s social activist bloggers continue to gain traction.
What’s The Endgame?
Dale says China has implemented – or announced – a number of key reforms. Among those either in the works or on the launch pad:
- Bank deposit reform, including interest rate liberalization and some form of deposit insurance
- Deepening of financial markets, including increased supervision, better central bank intervention policies, and financial crisis policy
- Currency policy, including a looser exchange rate trading range and more flexibility on dealing across China’s borders
- Capital account policy, allowing freedom of investment to attract portfolio flows, but also to permit Chinese to invest offshore.
Conclusion: Read My Lips
China’s financial and political system is, in the words of one senior official, “unbalanced, unstable, uncoordinated, and unsustainable.” But Dale reminds us, this situation will only turn into a full-blown crisis if there is a triggering event. Dale says China’s economic policies are well suited to address the myriad problems facing the nation.
So, can they do it?
China has accomplished most of the easier reforms. The bad news is, that still leaves the hard ones. Dale points to historical precedents, and to recent analysis by the IMF, that indicate China can thread this needle, but he cautions this situation is so complex there is no way to predict the final outcome.
Still, Dale says policies adopted by the Party all point to the right solutions – if they can be implemented both effectively, and on time. Says Dale, “Chinese officials almost always do what they say.” That should make for a refreshing change while we bite our nails waiting for the next financial crisis.
For more on Darius Dale’s work on China – and more on Hedgeye’s Macro coverage – please go to www.hedgeye.com.