Last Tuesday, I was writing about preparing your portfolio for recession. And I mentioned emerging markets, mostly in a negative way. I know Jeremy Grantham has been talking up the relative value of emerging market equities. Nevertheless, I have doubts. Let me tell you why.
Hot money flows and the emerging markets
Let’s start with this:
After a debt-fueled boom and a huge influx of hot money due to high interest rates, its currency and banks collapsed under a fleeing of foreign money and huge losses. The government nationalized the banks’ debt, only to find the banks were too big to bail. The Icelanders rioted on the streets, a sovereign crisis ensued, and the government was toppled.
That’s how I described Iceland back in January 2010. Iceland’s economy performed marvelously for a very long while, attracting a lot of foreign investment, close to 50% of GDP at one point. But imbalances built up on the back of this. And when foreign investors recognized the dangers associated with these imbalances, they fled. Eventually, the IMF stepped in. You can read their take on the situation here.
The moral of the story for emerging markets today is that all of the hot money flowing into EM can and will leave as soon as global growth slows meaningfully. Countries that are the most fragile, with large current account deficits like Turkey, will buckle.
But their plight will infect others as a wholesale retreat ensues.
And this is especially true now because liquidity, rather than leverage, may be the Achilles’ heel of this business cycle. In a liquidity crisis, good assets are sold to raise capital because bad assets cannot be sold. And so, asset price correlations increase as markets fall, exacerbating the fall.
Jeremy Grantham and emerging markets’ relative value
So when I see the relative value of emerging markets, I am not moved to dive right in.
Now, to be fair, veteran value investor Jeremy Grantham sees a big opportunity. I wrote about his view in January:
For individual value investors, rotate out of the US and go into emerging markets. They should keep cash more on hand as well. Since the US is so over-valued, Grantham also recommends putting a minority position in developed economy stocks ex-US – i.e Europe, Japan, Australia, etc.
Put as much as you dare into emerging markets, Grantham says – 50%! And he says you can get exposure via index mutual funds as well as ETFs. His view: Emerging markets represent off the scale relative value.
But as I discussed in February, it’s “a big leap for the average investor to move away from a portfolio of 60% domestic equities and 40% domestic bonds. Moving to a portfolio laden with exposure to countries and markets of which one has no knowledge may be a leap too far. I don’t see the average US investor going there when US equities have done so well.”
I don’t see it happening. And even if it did happen, big emerging markets like India have run up 145% in the last four years alone. That doesn’t speak to tremendous value. Those markets may offer relative value. But that will prove meaningless in a market downturn.
Has another EM crisis already begun?
There are signs that EM has started to fall apart already.
As the euro hits its weakest levels versus the dollar in 2018, it’s worth noting that emerging-markets debt has been heavily correlated to the fate of the euro. Here’s a chart of EURUSD versus the price on the biggest local-currency EM debt fund: pic.twitter.com/Ph7LccJXpS
— Lisa Abramowicz (@lisaabramowicz1) May 7, 2018
It’s early days. So I wouldn’t call this a crisis. What I would say, however, is that the Fed’s rate hike train is doubly negative for EM. First, it increases the real value of debt for the large array of US dollar debtors in the EM universe by boosting the US dollar. Second, the previous low rate environment enabled the build up of large amounts of external debt in EM. And so, it isn’t just liquidity but leverage at issue in the emerging market space. The IMF has recently warned on this issue.
But it is definitely about liquidity. Last summer, Argentina issued a 100-year bond due in 2117 that was 3.5 times oversubscribed. The yield was only 7.125%. And the bond actually traded up as the year went on and the US yield curve flattened. In 2018, things have been considerably different. And this is due to the Fed’s hawkish tilt. Markets are only now catching up to the Fed’s forward guidance. And that has had a very negative impact on the Argentina issue, now trading well above its issuance yield.
Similar to the Iceland example I used at the outset, Argentina has just raised interest rates to 40% to forestall a currency and bond market collapse that seems to be forming there. That’s a clear liquidity issue. And it could get a lot worse.
So there’s no reason to overweight EM here. If anything, you would want to underweight and wait until any global recession has come and gone. At that point, both relative value and liquidity will be on your side. Until then, emerging markets will be a risky bet.