So this is spring?

Spring is supposed to be the season of renewal and rebirth, from the Prague Spring to the Arab Spring, hope springs eternal. Here in Quebec we have one of the nastiest elections I have ever witnessed, and any green-shoots outside my front door were buried by today’s snowstorm.

I confess I felt a little uneasy suggesting the other day that spring had come to the Emerging Markets. It’s always so much easier to stick to consensus and let someone else tread on the landmines first. As Keynes said, it is better to fail conventionally than to succeed unconventionally…

Still, there is no better feeling than when you do get it right. 

I should also tip my hat here to Adrian Mowat at JP Morgan. He has been consistently counter-consensus on Emerging Markets this year, and I find his positive outlook very appealing.

Markets certainly took heart from the lack of escalation in Ukraine, recognizing that the annexation of Crimea is a done deal. One may not like Realpolitik, but sometimes it is the best we can do. Meanwhile, once it becomes clear that things are not going to get worse, the only sensible thing is to make the best of a bad situation.

I would, however, argue that the rally we have experienced in more than just making the best of it.

As I mentioned in previous weeks, Fed tapering hasn’t had any effect on the ability of countries to fund themselves, and they have already raised materially more than they did during the equivalent period last year.

The biggest of the “unknown unknowns” this year has been Chinese moves to increase uncertainty in trading of the Yuan. By allowing their currency to depreciate against the Dollar, and widening the trading band, the authorities have killed the carry trade – Borrowing USD and converting the proceeds into the Chinese currency to benefit from the ever-increasing currency. Because that borrowed money has to be paid back, it has pushed the dollar up and US interest rates down, countering much of the effects of tapering. The US 10 Year bond yields 2.72% currently, which certainly does NOT represent a huge hurdle for foreign borrowers.

More recently, S&P followed through with the ratings downgrade on Brazil that I discussed in one of my initial posts, and the markets did precisely nothing on the news. In fact they actually rallied. The lack of negative action may have been related to the change of outlook to stable, since everyone knew that the downgrade was inevitable.

It may also have been obscured by the news of a corruption enquiry at Petrobras concerning the purchase of an oil refinery for $1.2BN that was really only worth $40M. Although she is not directly implicated, President Rousseff was head of Petrobras at the time of the purchase, and it has dented her credibility as a technocrat. If she had the wool pulled over her eyes on this, what else has gotten passed her?

It is telling that an event that might derail Dilma’s election prospects should cause the markets to rally. It just goes to show how badly she is deemed to be running the economy.

Yet the fact that a corruption investigation is taking place is an incremental improvement, and people are starting to look for the incremental change, such as Petrobras admitting to analysts that the numbers in its revised 5 year CAPEX plans don’t add up, and they need to look at improved cost controls. They also made it clear that the Government will give them another price increase to close the import parity gap. At the turn of the year, both these pieces of news would have been taken negatively – Brazil continues to be run badly – now they are being interpreted as Brazil recognizing it is run badly and starting to do something about it.

So the focus on Brazil is switching to what happens after the elections. If Dilma stops mismanaging things but actually tries to repair the damage, what can she do without too much shoving and losing too much face?

Elsewhere, the improvements to the current account in Indonesia appear to be solid, and the expected winner of July’s Presidential Elections Joko Widodo appears ready to tackle two of Indonesia biggest structural problems, namely poor infrastructure and the huge amount of money wasted on the fuel subsidies. The first test will be parliamentary elections to be held in April, with early expectations that his party can double their seats to around 35%.

It would be overly optimistic to say that we are now living in the best of all possible worlds.

Thailand, unfortunately, appears to be bogged down in its never-ending psychodrama. The opposition Democrat Party can’t beat the Thaksin Government in the polls, so they are boycotting them and using the courts to tie the Government up in procedural issues in an attempt to discredit them in the eyes of their supporters. As far as I can tell, their policies look more like scorched earth than anything else, and I remain confused by the relative strength of the market.

Sadly the flicker of hope that was the new SICAD2 FX system in Venezuela already appears to be snuffed out, keeping the focus on the here and now.

Just to recap, Venezuela has 4 exchange rates, the official rate decreed by Chavez at 6.3/$, the secondary rate of 11 in SICAD, the new rate in SICAD2 of approximately 57/$, and the unofficial rate in the parallel market which is somewhere around 70.

The misalignments of the exchange rate is a major cause of the shortages of everything from pharmaceuticals to toilet paper; although vital medicines and food are supposed to be imported at VEB6.3, no-one is stupid enough to sell dollars at that price. SICAD was supposed to solve that problem by auctioning off $200M or so every week at a more realistic exchange rate. Unfortunately the market demanded more dollars than that, and the Government failed to deliver even the $200M. When the VEB11 rate was set it was already too strong, and the rampant inflation since then has only served to make the situation worse, hence the third tier.

SICAD2 was supposed to be unconstrained, with rates set by the market unhindered by the Government – a huge ideological shift by the highly doctrinaire administration.

The lower exchange rate would close the budget deficit but it would drive up inflation since so much is imported; a dangerous thing when people are on the streets protesting. Unsurprisingly, the Government appears to be backtracking already, and the rates in the parallel market are falling again as citizens scramble to protect their meager savings.

Meanwhile Air Canada has stopped flying to Caracas because they haven’t been paid; arrears to international airlines are believed to have reached $3.5BN or so at the old exchange rate, whilst the Government is expected to revalue those arrears to the new rate, meaning they will only ever get cents on the dollar.

Despite the blanket of snow outside, the noisy old raccoon that was jumping up and down on my roof last week tells me that spring is really here. The renewed focus on reforms and the possibilities of future Governments suggests the markets are feeling it too.

Hiding in plain sight

Michael Hartnett at Merrill Lynch is a great guy and a great strategist. He manages to distill his thought clearly and concisely, and is able to look at problems from a variety of angles.

One of the indicators he uses is to look at how much money is flowing into or out of the markets. If an abnormally large amount of many has flooded into a market it becomes harder to argue that the story is undiscovered. A big sell off suggest a bottom has ben reached, at least temporarily, and now is a likely to buy.

Like a lot of managers, I have been waiting to see a big final sell off in Emerging Markets to put an end to the long slow “death-by-a-thousand cuts” we have had for 20 weeks now.

The logic is pretty simple. What we are looking for is the last hold-outs to capitulate and to dump their last holdings in one big flush; After the Mexican devaluation in ‘94 I advised my Global colleagues for weeks to get rid of their Mexican holdings. They, however, insisted they were not material and that they should hold them for recovery. Eventually they got so frustrated with the constant slow declines that one day they demanded we just dump the positions – “Get this crap out of my portfolio NOW!” was how they put it. They pretty much hit the bottom of the market.

In recent weeks we have seen a lot of turbulence in the markets, but no big cathartic sell off. I wait anxiously for Michael’s analysis ever Friday in his “Flow Show” report, only to be disappointed that we remain stuck in neutral.

At the same time I have looked at the various drawdowns we have had and I can hints of that final flush out, so I looked at what the “Fragile 5” have been up to in recent weeks, and was surprised by what I saw.

Just to recap, the “Fragile 5” are Brazil, India, Indonesia, South Africa, and Turkey. They are the five countries that analysts are most worried about because of their anticipated financing needs for 2014 whilst Fed tapering means it will be hard for them to raise the money.

By the end of February, bond issuance by Emerging Market Countries was up 40% year over year, at just under $30BN. JP Morgan estimated that was equivalent to about 1/3 of this year’s needs.

Here are links to the price charts of the various Exchange Traded Funds for the Fragile 5 stock markets. Only Brazil and Turkey are below their 50 and 200 day moving averages, and even Turkey looks like it has broken out of its down trend. Indonesia looks to have broken out upwards, and India looks like it could follow suite.

Brazil

Indonesia

India

South Africa

Turkey

When Indonesia started to rally, my initial reaction was “Dead Cat Bounce”, but it has gone on so long and been so sustained, that I have to seriously rethink my position. Investors clearly believe the improvements to the current account are permanent and that vulnerability has materially decreased.

India is getting a lot of support ahead of the elections, as Narendra Modi of the BJP appears likely to be the next Prime Minister, the prospects of meaningful reforms grow.  

In Turkey, markets appear to have taken far more courage from the central bank’s interest rate hike in January than I had expected.

Although it is still early days, I hear the hedge funds have stopped shorting Russia, with several already closing out their shorts as long-only investors start to throw the towel in. Tomorrow’s reaction to today’s Crimean vote will be interesting.

In China this week, Haixin Steel looks like it will be the next company to default on its debts, sending the iron ore market, global suppliers, and global steel companies into free fall, despite this being a relatively unknown company outside the top 30 Chinese producers. Its problems were well know and well flagged as Rio stopped supplying it in 2012. Iron ore in China fell 10% during the week, hitting levels not seen since 2009.

I had closed a short on Brazilian steel maker CSN a couple of weeks ago during a previous period of turbulence at $4.51 and I was thing in I was pretty smart. The Haixin news drove it down to a low of $3.64! That is just background, what is really interesting is that talk of a share buyback drove the price on Friday up 13%. To my way of thinking, the huge final sell off had been a “Get this crap out of my portfolio NOW!” moment.

Like most men of my age, certain phrases are guaranteed to scare the living daylights out of me: “Dad, can I borrow the car”, “Daddy, this is my Boyfriend”, and that great broker quote “This time it’s different” will all push my buttons the wrong way.

So I need to square this circle; is there something in the recent market action that can confirm for me that we are broadly speaking at the bottom, without there being a cathartic capitulation, and with out it being “different this time.”

Turkey was unquestionably the weakest of the Fragile 5 and the market everyone loved to hate. Instead of pouring out platitudes about the market not giving them credit, they doubled interest rates from 4.5% to 10%.

Brazil was to my mind the least vulnerable of the group given its huge FX reserves, and although they did not act decisively, they did act early. They have been raising interest rates for nearly a year now even as the economy sinks into a recession. Their “normalization” of fuel prices was somewhat half-hearted, but from a Government that was firmly behind the curve, it was a significant volte-face.

Meanwhile, in specific area, such as CSN, there are individual signs of that BIG cathartic selling pressure, but it is very concentrated. We are not seeing contagion.

And finally, as shown by the ease with which all these countries have been able raise funds so far this year, tapering has NOT been the beast everyone expected. Like the Hound of the Baskerville’s, it has not barked.

So what has changed is the Global backdrop. Fears of a credit crunch for Emerging Markets were overblown, and the measures put in place have proven sufficient to counter the real rather than perceived risks. The long slow shedding of EM assets over a record period of time has shaken out many of the non-believers, and those that are left seem more likely to add to positions on weakness rather that throw their towels in.

It’s been starring me in the face.

Half a league, half a league

Last week was not a week to write a blog.

Although the Russian invasion of Crimea was the major event and had the expected and inevitable effect on the markets, it was so overwhelming event that it drowned out any thoughtful discussion. Best to let things settle down a bit first.

As entertaining as all the sturm und drange about the invasion has been, it is actually pretty pointless. Western Nations are not going to do anything dramatic, and token visa sanctions stopping oligarchs and friends of Putin visiting their London mansions just mean they will spend more time on their yachts.

Bloomberg has gone so far as to post “Russia’s Ukraine problem in six stark lines”. All good stuff, but Putin doesn’t care. He’s rich enough and protected enough; he measures his “success” in different ways.

The UK journalist, Jeremy Paxman, recently described how he felt modern society would never support a rerun of World War 1; we are too self obsessed and hedonistic. The days of sending in a gunboat are even the Light Brigade are long gone. That is NOT necessarily a bad thing, but it does make effective sanctions harder. I am sure Paxman is right, and no doubt President Putin feels the same.

What matters to Putin is rebuilding the image of a strong Russia and reversing the humiliations, as he sees them, of Russia since the fall of Communism. If the Western Powers are so pissed off with him that they are holding emergency meetings, discussing sanctions, or moving military hardware strategically, that means he has a result.

I cannot begin to fathom where this particular story will end, and frankly I don’t think anyone else does. Of all the talking heads out there, someone will be right, but we won’t know until the end who that it is.

Russian stocks are cheap. They were cheap before this invasion, and they will remain cheap for a very long time. I would venture to say they will remain cheap until Putin is clearly on the way out (Whether the ensuing rally will be a false dawn or not only time will tell, but it will make for a fun ride). There will still be opportunities there, although many will be “rentals” for a while. I am looking for real businesses that don’t depend on Government connections and that Putin won’t find a “strategic” need to get involved in.

In the mean time, Europe has a serious problem; it is too dependent on Russian gas.

It is particularly vulnerable to further escalation in the Ukraine, but ultimately it is vulnerable to the whims of Russia. Most people would probably say that Russia has too much to lose by cutting off supplies to Europe entirely, and I would agree, but so much can go wrong in a heavy winter; a few production problems in Siberia, a faulty valve in a pumping station, new monitoring equipment not working as planned…

So I can certainly see Germany quietly restarting its nuclear electricity program to give itself more energy choices. Realpolitik will mean that any announcement will try to avoid any linkage, but I would expect confirmation over the summer that the Government has been “running tests” as it slows down the decommissioning process.

Western Oil companies will pour into the Ukraine to exploit their shale gas, Europe’s 3^rd largest reserves. Ukraine needs the money desperately and the West needs the gas; it’s a marriage made in heaven

Chevron and Shell have both signed deals already, but with the ancien regime. I’m sure, given her history, Yulia Tymoshenko will be easily persuaded to allow such contracts to stand and will encourage the newly elected president to take the same approach. Other former Soviet Satellites, such a Lithuania and Poland, will also accelerate development of their shale reserves.

Elsewhere, the most exciting thing to happen was a bond default in China, that some people are calling China’s Bear Sterns moment. Bear Sterns was famously “saved” by JP Morgan, and markets continued to rise for several more months, thinking that the credit crisis had been averted. The bankruptcy of Lehman Brothers a year later showed the folly of that over-confidence. I think the comparison is a little misplaced myself.

As I have mentioned before, China needs bond defaults so that investors start to price risk correctly and they can start to control the runaway credit in the shadow banking system. Allowing such defaults, especially in an environment where they go against vested interests, is always painful. The trick is going to be allowing sufficient defaults to take place to allow the credit cycle to work but without so many happening that a complete credit freeze occurs leading to a complete rout.

The process becomes more complicated in China where a default can very quickly be seen as a punishment of someone who did not have the right connection, reinforcing the graft and influence peddling that the Government is trying so hard to reign in.

Although this default was widely flagged ahead of time, it has set the Rumour Mill into high gear, and the market is now awash with stories of banks calling in large numbers of private loans, steel mills being forced to shut down….

Complicating the picture are some pretty awful Chinese February export numbers, down 18.1% year on year when expectations were for a gain of 7.5%. It is highly likely that these awful numbers are a product of the usual distortions that occur around Chinese New Year, as the numbers for the first two months of the year only show a decline of 1.6%. Given that the Chinese authorities are also working very hard to squeeze out the rampant over and under invoicing that plagues Chinese trade data, that is probably an OK number.

All in all, I’m starting to get encouraged that an awful lot of very bad news is in the market. We haven’t seen one of the big blow offs that usually mark a turning point, and that makes me nervous, but several of the most vulnerable markets have actually rallied in recent weeks. Barring a plague of Frogs, it is hard to imagine what isn’t being discounted at current levels.