In Part I, we covered the early cycle associated emerging market economies. Investors are increasingly interested in emerging markets because of the higher prospective returns associated with them.
While interest rates on cash and bonds are virtually zero across the main developed markets – US, developed Europe, and Japan – the prospect of higher returns in other parts of the world can be much more.
On top of that, there’s the diversification element of investing in foreign markets with respect to different sources of cash flow and also different currencies. Investors tend to be biased toward their own country’s stock market and toward their own currency (particularly if they live in a country or jurisdiction that has a reserve currency).
Effective diversification and having a balanced portfolio that can do well in any environment can improve your return per unit of risk more than anything else you can practically do.
Emerging markets and “being global” can be a part of that process.
Emerging markets and Phase II
No two countries are the same and many never get out of the early development phase. For those that do, the events and time it takes are never the same. We can, however, build archetypical examples based on history and logical cause-effect linkages that drive cycles forward.
In Part I we covered the early cycle. This is where productivity increases, incomes rises, more capital inflows come in, debts are in line with incomes, incomes are line with productivity, and the country has a healthy balance of payments situation.
Part II is dedicated toward what we’ll call “the bubble phase”.
The bubble phase
When bubbles occur, they do so because of a self-reinforcing loop.
Productivity growth, income growth, and debt growth feed asset returns, which reinforces strong capital flows, and favorable economic conditions.
The capital that flows in during the early stages helps produce quality returns. It was invested in a productive way and caused asset prices to rise. Whatever is profitable attracts competition. Those profit margins naturally recede when capital flows in at a higher scale and exceeds the rate of productive investments.
During the bubble phase, the prices of the assets and/or the currency increase and the amounts purchased on credit (i.e., borrowed money) also rise.
Financial assets are securitizations of future cash flows. So, the price is particularly important because it’s the present value by which those future cash flows are discounted.
While investors and traders can make money from speculative bubbles (even a lot of it), they need to be especially concerned when assets that they hold rise above what’s feasibly sustainable.
Most investors don’t do a good job of this because of the way most react to rising asset prices. Something that’s gone up in price is typically perceived as a better investment (rather than a more expensive one) whereas something that’s gone down in price is typically viewed as a worse investment (rather than a cheaper one).
In the bubble phase, the prices of these investments increase beyond their capacity to produce good returns going forward. Nonetheless, the borrowing and buying to get long the markets for these assets continues simply because prices are rising. Debts rise relative to incomes.
Benefits to the currency
When capital inflows are strong and/or staying in the country or currency, this helps the exchange rate and the economy.
It also makes the central bank’s job easier.
It is broadly known that central banks manage policy to balance out inflation and growth outcomes so they can exist in the appropriate balance. Having the right balance between growth and inflation, also known as economic capacity utilization, is one of the main three market equilibriums that we track.
But it is not as well-known that it is easier to achieve higher output per unit of inflation when capital is flowing into a country/currency relative to when it’s flowing out. They can get more growth per unit of inflation.
This is due to the ability to use these positive capital inflows to increase FX reserves (which can be lent out or invested), lower interest rates (helps credit creation), and/or appreciate the currency. The central bank can decide among this menu of options in terms of how to use this advantage.
The economy usually booms during the bubble phase, though sometimes the currency rises and the economy grows more slowly. (A strong currency can also be a drag on growth because it can reduce export competitiveness and the cost of goods and services more broadly.)
The rise in the currency makes assets denominated in the currency desirable to own. On the same token, that makes liabilities denominated in other less attractive currencies also desirable to short. So, foreign investors effectively use their own currency (either cash or credit) to buy the foreign-denominated assets.
The setup for a reversal
Because the rise in asset prices tends to cause an extrapolation that these conditions will continue, the country becomes “over-invested” such that it eventually tops and reverses.
During this phase, the total returns to foreign investors are attractive. Both the assets and the currency they’re denominated in rise. Domestic outflows slow and foreign inflows heat up.
Bubbles start to emerge in debt and equity markets. This is characterized by debt rising in excess of output. An especially important sign of a bubble is when more households and companies begin taking on more debt to pay off existing debt. (Investors and policymakers usually catch on that this is occurring eventually.)
Nonetheless, because the country’s financial assets are going up, investors believe they’re great to own and anyone who doesn’t own them is missing out on the action. Other investors want to be in the “hot market” for fear of missing out.
But when a market gets excessively leveraged and overpriced – i.e., the cash flows won’t be high enough to support their present values – it’s becomes vulnerable to a reversal.
Typical conditions of the “bubble” phase
– The central bank increases foreign exchange reserves.
– The currency increases and typically becomes overvalued on purchase price parity (PPP) basis (usually by 10-20 percent).
– Foreign capital inflows are strong, on the order 8 percent of GDP typically and in many cases higher.
– Booms in emerging markets naturally come during bull markets in reserve-currency countries where credit is ample and riskier foreign investments can be made.
– When economic conditions are strong globally, this tends to boost commodity prices.
Many emerging markets rely heavily on selling commodities, particularly oil and gas rich nations. Strong commodity markets boost incomes and help contribute to increased investment.
– The country’s equity markets go up, often increasing by 20 percent or more annualized for several years before they top.
Many entities, from local businesses in the country to foreign investors and companies wanting to get long the assets, build up long currency positions.
When there is a continual economic reward for doing something, many different parties participating in it become accustomed to it even when the conditions that supported it fundamentally are changing. A big part of the rise is not inherently economic after a point, but psychological.
Oftentimes, they do it without consciously recognizing it as the exposure gets built up in ways that aren’t always obvious.
For instance, local investors and businesses might borrow in a weaker foreign currency because it’s cheaper, stable (or weakening), and foreign bankers are eager to lend to the hot market. Foreign investors and businesses get long the countries assets, often leveraged through their domestic currency, establishing a long position on both the assets and currency.
Businesses in particular might establish a preference to hold their cash in local currency. And any cash from revenues in that country might not be hedged back into local currency, preferring to take, or willing to accept, currency risk.
The general idea is that bull markets tend to feed on themselves.
It has a positive feed-through into the economy. There’s also the natural dynamic of bull markets increasing asset values, which increase collateral available to borrow against, which increases creditworthiness, and the ability to borrow, spend, consume, and invest. Both borrowers and lenders are more willing to engage in transactions. Many different entities get involved in this process of getting long the currency and stocks of that market.
– The rise in foreign capital inflows helps finance an increase in consumption.
This leads to a greater demand for foreign goods.
– Imports begin to rise faster than exports
This creates a current account deficit where more money, through this channel, is leaving the country than entering.
The fading boom
As the bubble moves forward, the number of productive investments declines. Yet more capital is seeking them out.
The economic conditions that made the country attractive in the first place – cheap labor, rising productivity – fades with rising incomes and debt.
Instead of productivity gains fueling growth, debt becomes increasingly relied on. Foreign financing also becomes a bigger part of sustaining the growth in their economy and markets.
This leads to a buildup of foreign debt denominated in non-domestic currency. This foreign debt uptake is a general feature of emerging markets for several reasons:
i) They do not have a reserve currency. It is scarcely used as a means of exchange or a store of wealth globally. This means that it’s hard to get other entities in foreign countries (corporations, governments) to borrow in it. Therefore, they tend to borrow in a reserve currency, mostly US dollars and to a lesser extent EUR and JPY.
ii) Their financial institutions and broader financial system (non-bank lenders, broker-dealers, fintechs, insurers, etc.) is not well developed.
iii) Domestic savings are low and not widely available to be lent out.
Asset prices rise and growth is still robust. This helps spending in the real economy, and also creates more foreign-currency obligations to pay.
Earning incomes in domestic currency and having debt in a foreign currency can create a dangerous asset/liability mismatch whenever there’s a reversal and investors begin moving out of emerging markets and back into the safety of developed markets.
A foreign currency going up relative to domestic currency is the equivalent to having a huge surge in interest rates. Some countries never recover. When this occurs, some need outside help (from the IMF or another external entity), some let things shake out as normal, and some experience bad inflation problems.
In the bubble phase, foreign currency debt is typically 30-40 percent of overall debt and often around 50 percent of GDP.
Overall debt burdens rise quickly. Debt to GDP ratio often rise by 30-35 percent over a 2-4 year period.
When debts are above incomes and incomes are above productivity – a characteristic of the bubble phase – economic activity is generally well above its potential. GDP readings are often 3 or more percentage points above potential on an annualized basis. China is a current example, where GDP has often been reported at 6 percent annualized. However, underlying productivity suggests only about 3 percent (or half this growth) is sustainable.
In the typical case, debt to GDP ratios during the bubble phase rise from about 100 percent (1-to-1 ratio) to around 150 percent (1.5-to-1 ratio).
The current account normally falls by about two percent of GDP, sometimes into a deficit but not always. This is natural as the currency rises, as imports become comparatively cheaper with a stronger currency and exports become relatively more expensive.
During the bubble, spending rises faster than income and productivity. This is unsustainable and requires a new flow of capital to keep driving it forward.
For the investor, or business owner with a vested interest in the country’s growth or structural bias to be long the market, it becomes increasingly precarious to be long a market dependent on continued strong inflows.
When spending patterns and debt conditions are rising faster than what’s sustainable, their markets and economy become more vulnerable. At a point, when a trigger occurs, years of economic growth and years of appreciation in asset markets can be unwound.
This trigger is often a tightening in monetary policy by the central bank (usually to rein in inflation). Nevertheless, it can also be triggered by other events as well, such as a natural disaster, pandemic, concentrated idiosyncratic risk exposures by a few economic/market participants, and so on.
i) Countries that rely more on external funding are most prone to big market and economic busts. (Markets are discounting mechanisms and will tend to lead the economy. The negative effects on markets also feed through into lower levels of economic activity.)
ii) Countries that borrow more in a foreign currency are more susceptible to market swings. The central bank only has control over its own currency. If a country borrows in its own currency it can respond to debt crises by changing the interest rates on the debt, changing the maturities, changing whose balance sheet it’s on, and/or creating more money to make up for the credit shortfall. Borrowing in a foreign currency, it can’t do so. A central bank can “print” money to fill the funding gap required to service the debt. But the money often goes into real assets (e.g., land in its various forms, real estate, precious metals) or out of the country. The currency dynamic can eventually lead to bad inflation problems.
These two elements tend to be intertwined – with foreign capital coming in and the borrowing tending to be done in a foreign currency. The countries the most dependent on foreign capital and foreign borrowing typically experience the most painful outcomes. These include declines in equity prices, the domestic currency, and domestic output, and increases in inflation and unemployment.
Covid-19-related money printing: Developed markets vs. Emerging markets
In developed markets, there’s no real need to be concerned about inflation outside financial asset inflation – the standard type that $15+ trillion of asset buying (G-3 central banks’ quantitative easing programs) brought from 2009 forward that lifted asset prices. It produced very little inflation in the real economy (goods and services) because the increase in money was simply offsetting the contraction in credit.
While monetary stimulants can be overused, they are not a problem in the early stages of a credit contraction when the money creation simply offset the loss in credit when debt is denominated in domestic currency. Policymakers have to do the calculations well to get the balance right.
While some who hold a traditional view might believe that a large amount of money creation will increase inflation, those who look at it from the level of the transaction will know that the total amount of spending changes prices.
The coronavirus crash created a period similar to 2008 where credit contracted in a big way.
If the amount of money spent on goods and services is simply offsetting a decrease in the amount of credit, it won’t make a difference to the price level.
In reality, if the amount of credit is contracting and the amount of money is not increased, then the amount of spending decreases and prices will decline.
Based on aggregate virus-related losses north of $5 trillion in the US alone (and close to $25 trillion outside the US), if the amount of money isn’t increased to at least that level, then real-economy prices will fall on aggregate.
Printing money is the easiest and most discreet way to pay for the drop in output. It is more politically tenable relative to your other two options – cutting spending or raising taxes. People will only take so much before voting out lower-spending or higher-taxing governments, so wealth transfers in this way usually don’t contribute much.
But it comes at a cost to the currency long-term. This is why investors seek out diversification with respect to currencies and currency systems. That is typically a hard alternative, such as gold and to a lesser extent silver.
While gold is said to be an inflation-hedge asset, you don’t need real-economy inflation for the “printing” of money to depreciate the value of money.
Inflation also isn’t likely to appear much in developed market goods and services economies because there’s a ton of debt relative to income. If central banks cut down on their accommodation only a little bit you know the brakes are going to work.
With the amount of debt in the world globally, about $325 trillion at all levels of the economy (individual, corporate, sovereign), a pre-virus global GDP of around $90 trillion and 3.5-4.0 percent annualized growth, all it takes it a 100-bp rise in interest rates for extra debt service payments to swamp all of the new annual income being produced.
The main thing is whether a country borrows in its own currency. Reserve-currency countries have debt crises that are inherently deflationary because the loss in incomes and credit contraction cuts spending power and prices decline. This is only rectified when central banks print money to fill in the gap.
As mentioned in a previous section, emerging markets, which typically borrow in foreign currencies, tend to have inflationary debt crises. The domestic currency they earn income in goes down and the reserve currency they borrow in goes up. They have a balance of payments crisis where the printed currency is moved offshore or into inflation-hedge assets and they get into a dangerous feedback loop.
To close the gap, the central bank needs to compensate investors with an interest rate on the currency that offsets the inflation rate and depreciation in the currency based on the underlying capital flow (i.e., the balance of payments deficit). When emerging markets with big foreign debt problem go through this process, this is the means by which you can work to identify the bottoms in those currencies.
Emerging markets during the bubble phase tend to have the following characteristics:
– Productivity and incomes are rising, but incomes begin to rise above productivity and debt tends to rise above income.
– Foreign capital inflows are strong, wanting in on a “hot market”.
– The central bank increases foreign exchange reserves, enjoying new capital inflows.
– The currency increases and then usually becomes overvalued.
– Bubbles can be aided by rising commodity prices, which many countries rely on to boost exports and increase incomes.
– The country’s equity markets are strong, but rely increasingly on debt-financed purchases of financial assets.
– They rely heavily on external financing because they do not have a reserve currency, a well-developed financial system, or high savings that can be lent out.
– Many entities become long the market in various ways, domestic and foreign, building up larger positions in the stock and currency markets.
– The past becomes extrapolated even if continued growth is dependent on credit and productivity is not keeping up.
– The rise in foreign capital inflows finances an increase in spending and demand for foreign goods, causing imports to rise faster than exports, resulting in a deteriorating current account balance.
– Increasingly, the economy and markets become vulnerable to a reversal.
– What triggers the reversal can be something like a tightening in monetary policy (typically to rein in inflation, which is normally higher in emerging markets than developed economies). However, it can also be caused by other things like a natural disaster, pandemic, the failure of certain key entities in the economy producing ripple effects, social and/or political turmoil undermining the fabric of the nation, and so forth.
In the next part of the series, we’ll cover identifying the top in these markets and how policymakers typically react.