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.

Getting Lashed by the storm

So the big sell off in Emerging Markets has finally started, looking like so much of the freak weather that has lashed North America and Europe this year.

 Last week we saw redemptions from the largest funds that matched those seen during the peak of the taper scare last year, the panic over the US debt ceiling in 2011, and even the Lehman’s crisis back in 2008. A couple more weeks of this and we will be in definite oversold/ buy Emerging Markets territory.

 We also saw some strong moves by several central banks, most notable Turkey, India, and South Africa. The Turkish move, raising the benchmark rate from 4.5% to 10% and raising the top rate from 7.75% to 12% was particularly bold. Some people even suggested that they had gone too far and that such big increases were not credible; the exit of Sterling from the ERM on Black Wednesday (16 Sept 1992) despite repeatedly raising interest rates seems to the model for such thinking.

 First of all I think this sell off is very necessary and very important. Emerging Markets are not going to be able to move forwards until this correction has happened for two important reasons. One obviously is that so many people have been expecting it that no one was going to allocate any capital until it had happened. They need to know, or at least tell their bosses, they are investing nearer the bottom than the top. The second reason is that I think it will end up showing that even the “Fragile Five” are not as fragile as bears have made out, and that this is NOT going to be a rerun of the Asia crisis of the late ‘90s.

 That does not mean that this is a storm in a teacup. I think the differences from the Asia crisis are greater than the similarities, but there are problems that need to be addressed. To misquote Anna Karenina, All well managed countries are alike; each mismanaged countries are mismanaged in their own way.

 Turkey’s rate rise will cut GDP growth significantly, and thus the skepticism about the rise’s durability. Rencap have already cut their GDP estimate down to 2% for this year, and others will follow – Merrill is still at 3.5%. Last week I described Turkey’s Finance Minister, Mehmet Simsek, as a “safe pair of hands”. I believe he has the ability to make Prime Minister Erdogan understand the gravity of the situation and that any attempt to force the Central Bank into reversing policy too soon risks losing control of the situation and making the crisis worse, jeopardizing Erdogan’s reelection hopes.

 Indonesia, probably more so than any other country, needs to cut fuel subsidies. As the FT points out, the Government in Jakarta was predicting they would eat up 11% of the national budget even before the Rupiah fell 20%. In domestic currency terms, Brent is trading at or near record levels in local currency terms across several Emerging Markets, pressuring budgets.

Tackling corruption is usually a good plan; I have been highly critical of Dilma Rousseff’s handling of the economy, but she was left a huge corruption mess my Lula, and she has tried to address it.

 In short, Governments need to follow up their stabilization plans with reforms. By and large, the countries that are suffering now have done very little to make their economies more competitive, preferring to sit back and collect the rents of the recent commodities boom and easy credit from QE. This complacency is not just a trait of Emerging Markets, as citizens of several Eurozone countries can attest, but currently the urgency is.

 To present a wish list of reforms for each and every country would be pointless, instead I will comment in the future on any that actually get implemented.

 So, what to do as we wait for those reforms? First of all, even if you believe they will happen at some point, you must remember they will probably come when politicians have their backs to the wall, meaning things could well get uglier first. If your career/ life savings depend on it, you should seriously consider waiting until you actually see something concrete happening.

 The second thing to think about is at what price you are comfortable owning something. Bear in mind, if you say today “I’d fill my boots up $20 cheaper”, what is going to make it $20 cheaper? Would you be trying to catch a falling knife, or would you be buying a cheap asset? Make sure you really know why you would buy something.

 As I mentioned last week, we had positioned some trades to benefit from the spike down, and we were able to close some shorts at really good prices on that day.

 Some of our long positions also fell back to levels we were comfortable with, but we only added incrementally so that we had money left over if they continued to fall.

 At every point you should ask yourself “What if I am wrong?” to make sure you are not being complacent.

Here is a nice video from John Authers at the FT.

Taper Tantrum

John Authers at the FT had a great video on when to Buy BRICs this week.


Given how all the research presented showed that Emerging Markets are very cheap relative to Developed Markets, it was surprising to see Andrew Pease sitting so firmly on the fence. No wonder people have such a dim view of consultants these days.

I did, however, take some comfort from him being as wrong as I was with regards to the onset of Fed Tapering; I was convinced it would not start until q1 2014.

Given the strength of US GDP revisions on Friday, in hindsight it is clear why the Fed moved when it did. Having said recently that I expect GDP estimates to get revised up in both the UK and the US in early-mid 2014, I confess I am now a little thrown that we are seeing that so soon.

Both inflation and unemployment remain below the Fed's targets, which is why the Fed has made it so clear that they do not intend to raise rates anytime soon. If, however,  GDP growth is going to surprise on the upside quite so dramatically, then QE will be withdrawn much faster than I am currently anticipating and the Fed will be forced to reconsider its rate stance. This is the biggest visible threat to my base case scenario, and with it the risk of a "melt up" in Emerging Markets.

If the risk is increasingly that of a "Melt up", the risk is not that higher interest rates depress EM valuations, but that the stronger growth in the US, UK, and Germany drags up EM earnings estimates. Merrill recently published an excellent piece outlining their thoughts for next year in Emerging Markets. They point out that bottom up earnings expectations for EMs are usually too high at the start of the year, and they generally fall as the year progresses. Expectations for 2014 are unusually low on this basis, whilst the economic outlook appears to have upside surprises.

Is this the year analysts start too pessimistic?

As the FT makes clear, we have seen massive redemptions from retail investors out of Emerging Market Bond funds ahead of Fed tapering, whilst I had previously posted a video from an RBC Portfolio Manager showing how there had been a lot of late selling by Hedge Funds who had been weak holders of EM debt. Long-term Institutional money had basically sat still. To me this says that institutions are now more firmly committed to EM markets, both debt and equity. During the Asian crisis the question was often if institutions should hold EM Assets, whilst now it is more a question how much they should hold. Andrew Pease's fence sitting was therefore more appropriate for the old way of thinking, whilst  I would advocate a bolder stance more fitting to the "modern' thinking; buy the cheap assets, but put on a hedge if you are nervous. I believe we are now at the "sell on the rumour, buy on the news" stage. The cheap parts of EM equities are now very cheap according to Merrill, with a lot of bad news built into the price; How much cheaper can they get, barring a crisis? You just need to pick the right stocks.