Markets; Looking But Not Seeing


Periodically, financial markets get themselves into a mindset in which they see only good news, when the bad is quietly ignored and lurking threats to stability are mentally locked in the cupboard marked, "do not open," down in the  basement, as we saw for example, in the two year run up to the last financial crisis. Meanwhile, prices grind higher but with growing internal divergences which give cause for concern. These periods invariably never end well.

My own open list of "bad things to worry about for 2011," includes the predictable running sores of the Eurozone, unemployment, food inflation, our own deficit and US State and municipal financing, (check this link to 60 Minutes if you need a quick brief and a window into what could happen in the UK if we don't control the deficit). Throw in some geopolitical risk from Korea, Mexico and the Middle East which isn't priced into markets and there is enough out there to keep us on our toes.

My friend Mark Tinker, who runs the Axa Framlington Global Opportunities Fund, has though, been looking under the covers in this guest piece and has concluded that we may be looking in the wrong place.

"In what is effectively the last trading week of the year, we are inundated with the usual year-ahead reviews. The instinctive contrarian in us is worried; everyone has turned bullish. Long experience tells us that these year-ahead pieces converge on a consensus view of what everyone is actually doing right now. Thus a Developed to outperform Emerging, Japan to strengthen, upgrade to US GDP on the back of the Fiscal (rather than QE) stimulus view has emerged. We actually agree with most of this, but...

We are worried that nobody is worried. Well that is not strictly true; we are worried that the only thing markets seems to be worried about (peripheral Europe) is not actually that big a problem. Moreover these issues are hardly "unknown". The nasty surprises next year will come from the unknown (or un-discussed) knowns; we believe that these will be margins in growth stocks and distressed selling in the event of a run on EM debt funds.

The biggest concern for us is that the market risk is almost certainly where nobody appears to be looking right now, Emerging Market bonds and currencies. The chart below is the iShares JP Morgan Emerging Market Bond fund, which caught our eye a couple of weeks back when the sponsors proudly announced that this particular ETF had passed $1bn in size..

 Emerging Market Bond returns starting to look less attractive

While such anecdotal "bell ringers" don't always work, they should certainly make us sit up and listen, especially given the price action of the last few days. We also know that the institutional flows into these areas have been enormous.

Our approach is both top-down and bottom-up and we use these prisms to look for risk as well as return. It was as much our bottom-up valuation work as our view on the dollar that led us to reduce China and increase Japan in November, but what we do know from (sometimes bitter) experience is that there are times when all the bottom-up analysis and understanding of the companies, their prospects and their cash flows and even their valuations can count for nought, and that is when there are distressed sellers. Hence a key part of our risk management is to look out for areas that may experience forced buying or distressed selling.

If we drill down a little, it gets more worrying still. This ETF, which is designed to mirror that benchmark, is 86% sovereign debt and is basically 8.5% each in Brazil, Russia and Turkey and 7% each in Mexico and the Philippines. These bonds all have coupons in the 7% - 8% region, but actual yields in the 5-6% region as they are all trading at a significant premium to par. The concern that we have therefore is that this premium is eroded. Look for example at the chart of the Brazilian 7 1/8th 2037 bond, one of the largest holdings in this particular ETF. Ouch!

Brazilian Bonds are falling particularly sharply

The premium to par is rapidly being eroded and capital losses are replacing capital gains. Our concern is that the flows into these EM bond funds are in many ways a play on the belief that EM currencies can only go one way, up. Most of the countries in this EM bond fund have current account deficits, reflecting at least in part the strong capital inflows into their bond markets (a capital account surplus is the accounting identity opposite of a current account deficit).

The Brazilian current account deficit in the year to October was a record $48bn, with central bank estimates suggesting $60bn next year. Now this is not a "problem" in GDP terms; it is less than 3% of GDP, but it is a chicken and egg situation. Part of the reason ascribed to the deficit is the strength of the real, which in turn reflects those capital inflows. If the real were to go down instead of up, then a lot of the attraction of Brazilian bonds to international investors would evaporate; we hear a lot of unhedged flows from Japan for example. For now, the real is stable, but if that were to reverse then the virtuous circle could turn vicious.

A more likely casus belli however is Turkey. Here too, there was a current account deficit in October, in this instance $3.7bn, versus a surplus in October 2009, and over half of it has been "financed" by portfolio inflows. For the full 12 months the deficit is running at $41bn, or 5.4% of GDP. Foreign purchases of Turkish financial assets went from $730m in 2009 to $15.5bn this year, according to the central bank. In October alone, international investors bought almost $1bn of shares and $1.5bn in government bonds. The policy response is to try and weaken the currency by cutting rates, and yields on the 2-year bond have already dropped to record lows of 6.75%. Moreover, if we look at the currency, it seems like the market has already got wind of this (the line moving up is a depreciation of the lira against the dollar incidentally)

The Turkish Lire is selling off sharply

The key question is to what extent does the fall in the currency undermine the attraction of a near 7% yield?

The real link therefore is currencies; without a central belief that emerging market currencies can only go higher, the attraction of their bond markets fades rapidly. Turkey has just cut interest rates to limit (they think) inflows, but this is folly in a market already subject to huge imbalances. Inflation is down from two years ago, but still running at 7.3%; in Russia it is 8.1% and Brazil 5.6%. Compare this with the funding regions; Eurozone at 1.9%, US 1.1% and Japan 0.2%.

Economic theory (often ignored) is that the internal and external purchasing power of a currency should be in equilibrium, i.e. if there is domestic inflation (purchasing power falls) then there should be currency depreciation as well. Such effects are captured through Purchasing Power Parity measures, popularised by the Big Mac Index. Of course right now we have inflation and currency appreciation. This is not sustainable. Some will take comfort that the emerging market bond currencies are "cheap" on a PPP basis; Philippines for example is 37% "cheap", but we would need to add that it has usually been 50% cheap. The Turkish lira however has moved from 13% cheap in early 2009 to 9% expensive, while the real has gone from 10% cheap in early 2009 to 27% expensive, as shown in the chart below.

The Brazilian Real is very over-valued

Obviously we are mainly concerned with the knock on effect on equity markets, the experience of recent years being that leveraged folly in bond markets is always paid for by liquidating "real" assets in equity markets. More important perhaps are the currency effects: the Istanbul Stock Exchange (ISE) is off just under 8% from its early November high in local currency terms, but to a dollar investor the losses are nearer twice that. At what point does the currency negate the asset class?

It looks like 2011 will be all about inflation, with particular emphasis on China, but we think that is looking in the wrong place. China will continue to grow and its bank lending will be quantitatively targeted to prevent too much asset price inflation, but growth will continue. Importantly though, this might not be "profitable" growth; output prices can be kept down while input prices especially wages, are not.

Inflation is, of course, also important at the micro-level in that it (ultimately) reflects a chain of pricing, with shifts in pricing power within it. For the last two years, the huge amount of operational gearing has reduced the importance of input prices in overall margins, but in 2011 this effect will diminish and our main concern at the stock level will be to avoid growth stocks that warn on margins due to higher input costs. This links into the earlier discussion on currencies; for many countries and companies the weakness of the dollar has provided a hidden benefit to input costs. This may not be the case next year.

The logical conclusion of all this (to us at least) is that when the Spanish government have to pay 5.4% on their 10-year debt and near 6% on their 15-year debt, and when US muni bond yields are back above 5.3% while even ultra-conservative Massachusetts have to pay 5.73% for their Build America bonds, what is the risk-return to a European or US investor on a 20-year Philippines bond that yields 5.7%? And in the manner of unintended consequences, if the peripheral EM bonds go, the currencies go with them. This in turn undermines the attraction of peripheral EM equities such that the liquidity constraints are tested. Liquidity is never seen as an issue on the upside...

As we close out the year, there has been renewed discussion of the Hindenburg Omen, which in effect describes a market where there are stocks hitting new highs and an almost equal number hitting new lows. The bears would say that means there is an increased likelihood of a crash (certainly there has not been a crash without a Hindenburg Omen). Maybe, but it also describes the (likely) world of 2011, falling correlations and an increased polarity among stocks.

Plenty to look forward to then!

Have a very Happy Christmas."