Emerging Thoughts

Before getting into this week’s post I just want to comment on this past week. Last week I spoke about the temporarily insane valuation of VW and how it was easy money to short it at 90 like it was temporarily during the past week. Well have I got good news for you, on Tuesday Volkswagen surpassed ExxonMobil to become the world's biggest company by market cap after Porsche announced plans to raise its stake in the German carmaker to 75% from 42.6%, triggering a short squeeze. As of Oct. 23, almost 13% of Volkswagen's shares were on loan, mostly to short sellers who were forced to swallow massive losses and exit their positions. The ADR traded as high as 225 on Tuesday which is a full 400% from last Friday’s (10/24) close of 53. They traded down the rest of the week to end at 122. Let me preface this by saying shorting is very risky and by nature has an unfavorable risk/return slope. That being said if you are a fundamental value investor, it is not very hard to see that the current price on VW is absolutely insane. Anyone who knows there financial history can see that this is a modern day corner and that fundamentals have been thrown out the window. For those with a strong stomach join SAC and Greenlight and try to ride VW back down to where it should be in the 30s.

In other economic news real GDP fell -0.3% in Q3, better than economists' -0.5% consensus, according to advanced estimates. Last quarter it grew 2.8%. The largest contributors to the downturn were lower prices for nondurable goods and a deceleration in exports. While the GDP shrinkage was more modest than expected, things will likely get worse before they get better. The key to this is GDP is a lagging indicator and the recent GDP number does not represent the pain seen in October or the pain we will see in November and December. I am not saying the markets will fall, I am saying spending will fall on a YOY basis. Although this may be painful for retailers and the economy in the near term I can think of nothing better than U.S. consumers tightening their purse strings and hopefully reducing some of that outstanding debt, not to mention I would love to get our savings rate up there, remember counting on social security to support you in your golden years is a fool hardy proposition.

One thing that is becoming starkly obvious is the stimulus package has not succeeded as many had hoped. It is slowly becoming more evident that another stimulus could possibly be needed. Another large stimulus in the range of $200bn + will be needed to offset the sharp drop in spending relative to income by US households and businesses (i.e., the increase in the private sector financial balance) that is now underway due to the tightening of financial conditions. If left unchecked, this retrenchment raises the risk of yet more adverse feedback effects between the real economy and the financial sector.

Aggressive government responses could limit the impact of the adjustment (in other words no action is clearly the wrong action) both directly via the fiscal boost and indirectly by stabilizing expectations and financial conditions. What is technically worrying about this is that the US budget deficit is already quite large and any further leveraging might damage the system (i.e. our old nemesis inflation might rear its ugly head). But taken in perspective this objection is misguided because it ignores the greater cost of letting the downturn continue unchecked. Net-net I think we will see our federal deficit continue to climb until we see substantial government action. Remember the Federal Deficit equals the sum of private sector surplus and net-foreign capital inflow. Although it is just an accounting identity, this equation has the following, very powerful implication: An increase in the private sector balance must raise the government deficit by the same dollar amount, unless it is offset by a reduction in the current account deficit. Historically higher private sector balances have been a bad thing. In principle, it would be nice to see a package that offsets the entire negative impulse to economic activity since further increases in unemployment – from a level that is already well above what’s needed to control inflation are – a pure social “bad”. In theory, one might argue that this requires an increase in government spending on domestic goods and services of 4% of GDP or a tax cut – which inevitably involves some “leakage” into increased imports – of 6% of GDP. In dollar terms, this would imply a massive $600-$900bn stimulus. Either way I would bet the next administration does something within their first month of office (that’s if something doesn’t get done sooner).

The recent weakness in emerging markets has raised concerns in developed markets about the overall impact on profits as well as the specific risks to companies with high revenue and net income exposure to EM. In general, until very recently, the highly exposed companies have outperformed the broader market and their more domestically exposed counterparts. However, the sharp reversal of performance in these stocks being seen currently reflects the growing concern about further EM activity weakness (For an illustrative example see IBM or YUM). While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.

Earlier in the year emerging markets were seen to as a pillar of stability since the credit crunch started to emerge in the summer of 2007. Three key factors were at play. Firstly, emerging market banks were seen to be relatively unaffected by the deepening crisis in the US mortgage market, secondly emerging markets were continuing to weather a slowdown in export growth as domestic demand remained robust, and thirdly most of emerging markets benefited from higher commodity prices as they were commodity producers. With the fall in commodity prices and the worsening of the global credit markets EM indexes and stocks have fallen sharply. Emerging countries typically have had limited access to USD funding in proportion to their IMF quota. The Fed, however, on October 30, 2008 announced that it is extending dollar swap lines to the central banks of Brazil, Mexico, Korea and Singapore so as to boost USD liquidity in those emerging markets. The swap lines amount to US$30 billion for each central bank. These swap arrangements allow central banks in the major countries to provide liquidity to their local banks without having to deplete reserves or tap the normal FX market. However, if central banks in the other parts of the emerging world want to provide their banks with USD without impacting the normal FX market, they have to use either their reserves, turn to the IMF or look at less orthodox measures such as capital controls. These fears have made it more difficult to roll over existing liabilities in global capital markets and even harder to issue more debt, putting pressure on countries that do not have enough liquid assets to offset the shortage in foreign liquidity. Asian countries are less exposed to this risk relative to Eastern European countries, Latin America and Asian economies that have recently come under pressure (like Indonesia and Korea) rank somewhere in the middle in terms of exposure. The growing focus on the vulnerability of Central and Eastern European economies has been reflected in weakening currencies in the region, prompting several EM central banks to tighten liquidity either by intervening in the FX markets (and reducing reserves) or through higher overnight rates (for example the National Bank of Hungary raised rates by 300 bps, while overnight rates in Romania reached a peak of 500% last week). Weakening currencies have two major impacts. First, Eastern European countries have borrowed in foreign currencies and will face higher repayments when their national currency weakens. Second, for foreign companies exposed to this region, they will have lower profits when they translate them in their reporting currency. Growth expectations for the region have come down aggressively. While Russian GDP growth accelerated to 8% in 2007-2008H1, the pace of activity had already slowed before the banking crisis hit. The slowdown started on the back of a rapidly tightening labor market and widespread price pressures. The banking crisis has significantly added to the problems. Despite significant injections of liquidity into the banking system by the Central Bank of Russia and Finance Ministry, inter-bank lending has ground to a virtual halt over recent weeks with significant negative impacts on banks funding. Working capital constraints have emerged and anecdotal evidence suggests this is causing stoppages at a number of manufacturing facilities; this will ultimately result in starkly lower productivity. On top of the risks to growth, several countries in the region have needed to turn to the IMF for financial support. While Iceland and the Ukraine have already negotiated broad packages with the IMF, Hungary reached an agreement with the IMF for a package amounting to US$25.1 billion (including €6.5 billion from the EU and €1 billion from the World Bank). Interestingly, in contrast to what we saw in the Asian crisis, the programs have less conditionality than in the past. These are likely to be supported by at least some extension of liquidity support from central banks in advanced economies through the expanded use of swap lines and similar instruments. Together these should boost investor confidence and trigger a return of capital inflows. However, the sheer size of the external funding requirements in these countries means that some may still have to experience a sharp contraction in import demand.

While it is difficult to get a firm conclusion about how much further weakness in EM is ‘priced into’ stocks, we can get some feel for it by comparing the performance of the companies most exposed to EM to their the local market, sector, and the related sector within the emerging markets. Overall, high EM-exposed banks and telecoms have only recently started to underperform the broader market and their own sectors. In both cases, however, the recent falls seem to have overshot their peers in emerging markets. Cyclical sectors such as basic resources and industrials seem to still be the most vulnerable to further emerging economy weakness. Amongst this group basic resources have possibly priced in the most emerging market weakness in terms of price action, while industrials seem to have reflected the least damage from emerging markets and would seem most vulnerable to further economic deterioration.
The real question in my mind is when the developed markets calm are the EMs going to be the first to “pop” back up? As the world is painfully learning, the problem with leverage is that it is much easier to create than to reign in. Banks can, in effect, create leverage out of thin air. For example, when a bank makes a loan, it creates both an asset for the borrower (the proceeds from the loan) and a liability (the obligation to repay the loan). However, if the bank wants to reduce its leverage, things are not so easy. The bank can either wait until the loan is repaid (which can take a long time) or sell the loan to a third party. And even if there is a secondary market for such a loan – and recently such markets have become increasingly illiquid – selling the loan does nothing to reduce overall leverage in the financial system. This is because of the iron law of finance: for every buyer there has to be a seller. The liquidity that the bank gets from selling the loan is offset by the liquidity lost by the party that purchases the loan. But this creates an obvious problem. If most institutions are trying to delever at the same time, then asset prices must decline until enough investors with sufficient liquidity are lured back into the market. Needless to say, this dynamic has the potential to be particularly damaging to emerging markets (as we have seen over the past few weeks). On balance, the question of whether we see another full-blown EM crisis (i.e. worse than it is today) will hinge on the speed and vigor of the policy response. Thus far, the response from policymakers has been encouraging, which suggests to us that a baseline scenario in which all but the most levered EMs face a soft-landing is still the most likely outcome. That being said I think it might be time to look into the best positioned EM. I personally am most fond of Brazil as I think they have the cleanest balance sheet and should benefit from either their strong natural resources or/and their buoyant domestic economy.

Hopefully next week I hope to present a stock idea, I know I have been saying this for some time, problem is I am finding a lot of flaws in numerous ideas so I have yet to find one that I am comfortable presenting. Rest assured I will find one, so keep reading.