This note was originally published at 8am on July 19, 2013 for Hedgeye subscribers.
“Never memorize something that you can look up.”
I used to have something of a photographic memory. Lately, however, a plot of my capacity for short-term recall and a YTD chart of Gold would probably be hard to distinguish.
I’d proffer that my bout with Cognitive Deflation is only transient and simply the byproduct of late nights with infants, serial overconsumption of caffeine, and serial under-consumption of exercise. At least that’s what I tell myself.
Either way, I’ve come to more closely relate to the aphoristic wisdom embedded in Einstein’s quote above.
With some beach time on the August calendar, I’m holding out hope the downtime catalyzes some needed cerebral exfoliation.
Back to the Global Macro Grind….
We have been negative on emerging market debt and equities for most of 2013 with #EmergingOutflows & #AsianContagion headlining our 2Q13 and 3Q13 Macro Investments themes calls, respectively.
The story of emerging market pain is one birthed from emergent strength in the U.S. dollar, acceleration in U.S. growth and the associated reversal in unprecedented Fed policy driving an expedited reversal in Hot Money & Yield Chase Flows out of developing economies.
We’ve presented the principal conclusions of our research and suggested positioning in recent presentations, but it’s probably worthwhile to take an illustrative, didactic tour of capital flows to understand how the cycling of capital into and out of emerging economies can work to propagate negative economic and market impacts in an archetypical scenario.
Capital Flows to Emerging Economies for 3 Principle Reasons:
1. External: “Push” flows occur for reasons external to the capital-importing economy and generally relate to relative investment attractiveness. Perhaps the simplest way to understand it is in the context of U.S. interest rates. If growth slows, policy turns easy and interest rates in the U.S. decline, investment yields available in emerging economies become relatively more attractive and capital flows accordingly. Historically, this has been the largest driver of rich-to-poor capital flows. It’s also generally the most volatile.
2. Internal: “Pull” flows are catalyzed by improving economic fundamentals, sound policy and/or trade & capital market liberalization initiatives. Pull flows provide firmer bedrock for sustained inflows.
3. Financial Globalization: Here we’d highlight the ongoing, global trend towards Financial & Capital market integration and the proliferation of conduit investment vehicles allowing broad institutional and retail access to developing economies. A secular shift in portfolio allocations towards international diversification holds positive longer term opportunity for developing economies. However, in compressed periods in which flows chase performance, it can work to amplify volatility in market prices.
It’s the potential transience of “push” and portfolio (i.e. equity & debt) flows that are of most concern to capital-importing countries, particularly given the reality of hyper-fast capital mobility.
So, what happens when the Hot Money starts to flow?
In a generalized model, the body of empirical evidence points to a number of discrete macroeconomic impacts:
1. Currency Appreciation: Absent Central Bank intervention the demand for foreign currency drives the exchange rate higher.
2. Consumption Growth: The influx of foreign capital provides for a higher level of domestic investment. This higher level of investment is generally accompanied by a decline in the domestic savings rate. Consumption rises as consumerism displaces saving.
3. Rise in the Money Supply & Inflationary Pressure: Stemming from a rise in economic activity along with any attempts by the central bank to quell the currency appreciation.
4. Widening of the Current Account Deficit: Don’t worry if you don’t remember the details about what the Current Account is. Here, it’s sufficient to understand that imports rise relative to exports generally due to an appreciating currency and rising consumption.
It’s not difficult to understand how the confluence of the above dynamics can work to drive recurrent boom and bust cycles for emerging and formerly, capital-rationed, economies. Consider how the interaction of the above factors, which initiates with a large influx of foreign capital, can work to drive a self-reinforcing cycle in both directions:
U.S. growth slows, Bernanke cuts to 0%, institutes financial repression and forces capital to search out yield. Capital flows into the EM economy causing increased investment, falling domestic savings and rising domestic consumption. Incomes rise alongside accelerating growth, driving a further increase in consumption in a positive, reflexive cycle. Further, foreign capital inflows along with diverted domestic savings provide a bid for real (i.e. housing) and speculative financial assets. Net wealth increases alongside inflating asset values. Faster growth, higher incomes, and rising net wealth all serve to increase capacity for credit. Credit expansion then serves to amplify the cycle. Everything is great, until…….
U.S growth starts to inflect to the upside, #StrongDollar starts to sniff out a Fed Policy reversal, and “push” flows begin to reverse.
When portfolio capital starts to exit, asset prices deflate and credit gets tighter, investment and consumption both decline. The currency depreciates, driving local inflation higher at the same time that aggregate demand accelerates to the downside. If demand is local and the debt is denominated in foreign currency, the debt burden on business is amplified. Declining demand in the face of a crashing currency and elevated inflation can leave policy makers handcuffed.
Thus, capital flows, this time the expedited exportation of foreign capital, catalyze a reversal of the boom cycle described above with some version of a self-reinforcing, contractionary cycle playing itself out.
Of course, country specific fundamentals, policy decisions, and monetary systems matter and understanding the prevailing risk for a particular country is more nuanced, but the generalized model described above captures the broader dynamics that tend to drive the cycle.
Further, given the large-scale proliferation of EM related investment vehicles whereby investors indiscriminately bought ‘international diversification’ without a real understanding of the underlying exposures, it’s unlikely they will be overly discriminate in their selling. Historical precedent suggests #StrongDollar driven outflows from emerging markets are protracted.
In short, we don’t think #EmergingOutflows have bottomed yet.
Hopefully the decline in my recollective ability has.
Our immediate-term Risk Ranges are now:
UST 10yr yield 2.49-2.74%
Enjoy the weekend.
Christian B. Drake