As we get a breather in the indiscriminate sell-off, I think it is a good time to consider what it is that actually drives the faith of various emerging markets.
Naturally, the easiest explanation currently is “tapering”, which is something I’ve been trying to fight for the last several weeks among the investors that I speak to. Alas, the power of the front page of FT or WSJ saying “EM is doomed as Fed tightens (sic!) the policy” is difficult to overcome. What is particularly worrying is that this sort of über-lazy argumentation is very often used by fairly young traders. The reason why it worries me is that those guys will at some stage be responsible for the way the market behaves and that spells all sorts of issues, especially when it comes to concentration of views and positions.
The “reasoning” is as follows.
A financial tsunami is coming because the Fed will taper. Therefore let’s try to look for another crisis of similar sort. Oh, we don’t need to look too far back as we’ve got 2008. Brilliant! So which position would’ve made me a billionaire back then? Shorting the EUR, receiving the xccy basis in anything-USD, selling all emerging markets, particularly CEE and a few more. So why don’t I do it again as “this time is different” never works. - Risk meeting at a macro fund
I honestly can’t tell you how much I hate such an approach. Probably as much as popular it has become. Meanwhile, people are forgetting the simple, transparent approach to looking at various countries, ie the balance of payments. Everything you need to know is there, particularly in emerging markets.
You want examples? Ok, a few recent things:
- Turkey. It is selling off not because of some protests or handling thereof by the government. It is selling off because the market has realised that the current account and it’s funding is not sustainable at the current level of rates. And this process started before the infamous Bernanke speech. The only way to tackle that is by adjusting the main culprit, ie the monetary policy. Not the currency. It is very common to confuse currency depreciation with the balance of payments adjustment. Therefore the correct trade in my opinion is ratesa/bonds rather than FX. With or without the taper.
- Egypt. Again, the balance of payments will tell you that the country was going to go bust even before the whole Morsi debacle started. Why is the current account so bad? Because the fiscal policy is too lax (subsidies etc). Will FX depreciation help? Nope, it might actually worsen things. Either way, what’s going on in Egypt has very little to do with Ben or protests.
- Hungary. It’s not selling off. How come? Debt stock is huge, after all. That’s irrelevant. The balance of payments is looking ironclad and that’s why the HUF is strong like a bison. Bernanke or not.
- Eurozone. How many people have lost their shirt on shorting the euro in the last couple of years. “The euro needs to crash to help the periphery” has been such a lovely slogan. But look at eurozone’s balance of payments. It is looking spectacular both on the current account side and on the funding component. Even the intra-EMU BoP is not bad (as represented by, pardon Lorcan, shrinking Target2 balances). And this is why the euro is not crashing. Sure, Bernanke’s testimonies could create some volatility but the “macro investors” should take a step back and see how poorly shorting the euro has worked and maybe rethink their approach.
- China. Here the situation is trickier because at face value the current account and financial account don’t seem to be problematic. But there’s a third component to the balance of payments, ie fx reserves. Equally important as the other two as it determines the level of liquidity in the local banking system (the central bank by accumulating reserves pumps in more local currency), which can then create all sorts of issues, including the unprecedented growth in credit/GDP. And this is why the Shibor market has become so unstable.
I could multiply those examples but the point is that it is my profound conviction that in most cases the analysis of the balance of payments will help you both ask the right questions and get you the right answers. This is also the place where policy mistakes are laid bare.
Therefore, stop trying to guess whether the market misinterprets Ben Bernanke in one or another way because – as the last few weeks have shown – this will stop you out of positions unless you are the luckiest trader alive (in which case sit back, relax, you’re all set). But go back to the basics. Have a look at the balance of payments and this will help you get above the monkeys who trade Bloomberg headlines and are proud when they’ve guessed whether it was a risk on or a risk off day.