Looking back at my previous recommendations the one thing that I have gotten wrong more often than not is my unfortunate bullishness on emerging markets. I thought now if ever was a good time to revisit this position.
Thus far various EM economies have taken quite varied approaches towards the crisis. Historically, emerging markets have reacted to crises by jacking up short-term interest rates, tightening fiscal budgets, and either rigidly trying to defend their exchange rates or, when that proves impossible, permitting large devaluations. However, during the current episode, as Friday’s surprise 100bp cut in Thailand illustrates, most EMs have opted to lower interest rates. Moreover, many are easing fiscal policy, and have taken the middle ground with respect to exchange rate management by letting their currencies depreciate gradually. In other words, EMs are trying to react to the global economic slowdown in the same way that most developed economies are reacting. But will the new medicine work any better than the old?
The reality is that countercyclical fiscal and monetary policy is a luxury that not every EM can afford, not every EM economy has the resilience associated with more developed economies. The good news for EMs is that, as a group, they have become a lot more resilient over the past decade. Total EM external debt to exports has declined from 152% in 1998 to 66% in 2008. Meanwhile, the overall EM current account balance has moved from a deficit a decade ago to a surplus of about 2.6% of GDP in 2008. The bad news is that in an environment in which advanced economies are likely to experience a nasty recession –GDP in advanced economies are expected to contract 1% in 2009 – the traditional reliance of many EMs on export demand will prove to be a handicap. Furthermore, the resilience to economic shocks varies significantly across EMs. For example, between 2000 and 2008, the ratio of external debt to GDP declined from 36.7% to 20.4% in Latin America, and from 28.2% to 16.5% in Emerging Asia, but increased from 45.3% to 50.5% in Central and Eastern Europe. Thus, we need to differentiate between countries such as China that are really part of the solution, in terms of their capacity to ease both fiscal and monetary policy, and countries where the fundamentals are shakier. This latter group of countries is at risk of experiencing significant balance of payments pressures if the global financial crisis were to worsen.
Russia looks vulnerable. Interest rates are negative in real terms, credit growth – at least until recently – has been very high, and the country has a weak inflation track record, marked by periodic bouts of extremely high inflation. Furthermore, the sharp deterioration in Russia’s terms of trade since the summer has left it with a currency that is overvalued. While debt payments (both private and public) due in 2009 are a manageable 9% of external reserves and 10% of exports and foreign income receipts, there is concern that a move by Russians to shift their deposits from Rubles to Dollars and Euros could put a strain on reserves, which have already fallen by $150 billion (25%) since August. The CBR has reacted by allowing the Ruble to weaken by 1% on three successive occasions over the past three weeks. These glacial moves stand in stark contrast to the forwards, which are now pricing a 27% depreciation against the Dollar over the next 12 months. As such, a large one-time devaluation would be appropriate, as it would help the CBR conserve reserves and give a competitive boost to the Russian export sector. On the fiscal side, Russia is expected to run a small fiscal surplus in 2009 and government debt to remain low at 8% of GDP, the high CDS spread on Russia’s sovereign obligations suggests that investors have become more concerned about solvency risk.
In Latin America, CDS spreads are pricing in significant default risk in Argentina and Venezuela. Sovereign spreads are moderate in Colombia, Brazil and Mexico, and relatively low in Chile. Real rates are quite high in Brazil and Mexico, and there is scope for both countries to ease monetary policy as inflation concerns begin to subside. However, while Brazil’s fundamentals have improved markedly over the past 5 years to the point that it has become one of the most resilient EMs, given the country’s history of hyperinflation, as well as its large negative net foreign asset position (43% of GDP) and somewhat overvalued currency, policymakers will need to stay vigilant in the event that the global financial crisis worsens and capital outflows intensify. Likewise, in Mexico, while the Peso is undervalued on a trade-weighted basis, a high ratio of scheduled debt service in 2009 (36% of reserves) may complicate the conduct of monetary policy.
Among the major EM regions, emerging Asia seems the most resilient, although even here, the Philippines and Indonesia look quite vulnerable. China in particular appears very resilient. While the Renminbi is now about 8% overvalued on a trade-weighted basis, total debt service in 2009 is projected to be only 1% of exports and foreign income receipts, and 1% of external reserves, while net foreign assets stand at a healthy 31% of GDP. Real interest rates are also positive (real deposit rates are about 3%), which gives the PBoC further scope to lower deposit and lending rates. Moreover, the country has no recent history of hyperinflation, and hence has more monetary credibility than many other EMs. The fiscal position is also strong. While the government balance is expected to shift to a deficit of 1.8% next year, government debt is low (18% of GDP), and CDS spreads indicate that the market is not overly concerned about solvency risk. China also has the fastest long-term growth rate of any EM, with an estimated GDP growth rate of 10.1% between 2010 and 2025.
In thinking about the market implications of this analysis, it is important to juxtapose the risks described above with how the market is pricing them. In a number of EMs, the market is pricing in significant tightening of monetary policy. Brazil is one market that comes to mind where this is obviously already priced in. I am still bullish on the long-term stories of select EMs, I would just be careful in selection. I will reiterate what I have been saying for some time, now is the time to be writing OTM puts on select securities that you would be interested in otherwise purchasing. It is just like putting in a limit order and getting paid to wait. With implied volatility near all time highs and the VIX at the highest 3 month realized levels since the Great Depression the premiums on some names are absolutely fantastic. For example, last week I wrote some Dec 35 GS Puts and received $1.60 up front! Those are fantastic annualized returns. The key to this strategy is you have to want to take delivery on the underlying security should it fall to your level.
While it is tempting to believe that a New Year will bring an entirely different set of market prospects – a new slate – the reality is often different. The start of 2009 is unlikely to bring a change in the dynamic of growth and the unlocking of credit that is required for risky assets to re-rate. While I do expect an inflection point in economic activity and the pricing of equities and credit markets sometime in 2009 it is likely to be from lower levels and later in the year. From a trading perspective (aka I am going off my gut, there is no real deep research backing me up) I would expect the current rally to continue (although at a more moderated tone) through the beginning of next year. After our new president is inaugurated and we start to see some ugly Q4 data, people will bid the markets further down. I would expect a bottom sometime in Mid-summer when I hope we might begin to anticipate the affects of Obama’s plan to save the American consumer. Fears of debt deflation are probably overdone – the mistakes of the 1930s, and Japan in the 1990s, are unlikely to be repeated as government action becomes increasingly aggressive, coordinated and unorthodox. But we live in an age where the unexpected happens – regularly. Investors are assuming the worst before they are proved wrong. Governments are likely to be seen as guilty until proven innocent, and so deflation, while unlikely, is likely priced as a growing probability in the near term. It is still too early in the process of growth deterioration and falls in profits for the market to start pricing in the next recovery. The credit markets need to right themselves before I can put any faith in this recent bear rally.
With all these speak of need for further government intervention I am amazed at how little structure the government plan has thus far. Apart from the still uncertain size of the stimulus package, there is even greater uncertainty regarding its composition. Infrastructure has been the top theme in the debate, but there appears to be limit to how much infrastructure spending can be carried out in the two-year timeframe lawmakers are considering and especially in 2009. Other options include state fiscal assistance, which is more or less limited to the amount of state fiscal shortfalls, and tax provisions. Ultimately, the first two options appear likely to have a higher multiplier than the last, but the last is by far the easiest to implement in large amounts and also has quicker effects. Near term projects do exist, but there is a limit. The Congressional Budget Office estimates that $18 billion in transportation related
projects are “shovel ready” and could begin within 120 days. The American Association of State Highway and Transportation Officials (AASHTO) puts this number at $32 billion. Meanwhile, the National Governor’s Association (NGA) has estimated that $136 billion in infrastructure projects – including not only transportation projects but other areas as well—are planned and ready to be started within the next year. It will be interesting to see where the final dollars go. My hope is that it will be spent useful i.e. not building bridges to nowhere in Alaska.
Going forward I think this market will turn into a truly fantastic time for hard core value stock pickers. One recent move that I hope everyone was smart enough to participate in was when Berkshire Hathaway fell below $80,000 (those are the A shares for those of us who are less fortunate I recommend investing in the B shares which are usually 1/30th the price). Berkshire fell due to fears of derivative contracts that expire in 10+ years. For more on this read the Barron’s article written two weeks ago or just look under Yahoo! Finance, I am sure there is a story on it. The CDS for a short period shot up on Berkshire to 5%, I would have loved to traded in those. The key to winning in volatile times likes these is being ever vigilante to take advantage of those sweet opportunities. I know I am watching both the equities, options, and convertibles market like a hawk for the once in a decade opportunity. If any readers see anything or would like to discuss some please feel free to post a question which we can discuss in greater detail. Thanks.