There is one absolute about markets, they eventually revert to mean, larger the disequilibria, the larger the reversions
What do collapsing emerging market currencies, oil, commodities prices, rock bottom interest rates, low inflation and sky-high equities have in common? Well, nothing really.
Normally, interest rates are directly correlated with equities. Markets demand higher rates when an economy is improving. Equities also rise on the expectation that corporate profits are rising. As economies improve, the demand for commodities and especially oil rises. With rising demand comes rising prices and rising inflation. But this is no ordinary economy. It is an economy that seems to peer through a looking glass as reverse opposite. One created by governments in general and central banks in particular that has piled up massive disequilibria.
To start with let’s look at currencies. We would expect that the Euro and the Yen would fall. They have both been intentionally devalued by their respective governments. But emerging market currencies have fallen as well. Among the fallen include the Polish Zloty, the Brazilian Real and the Mexican Peso. Currencies that would be expected to improve with the fall of oil, like the Indian Rupee, the Turkish Lira and the South African Rand have all fallen by 2.6%, 6.5% and 5.8% respectively. Most of that decline has been in the last two weeks.
Of course the Russian rouble has seen the largest drop. It has lost 85% of its value against the dollar this year. Obviously, markets are not worried about the collapse of Putin’s Russia. They probably are thinking that it serves him right for taking over Crimea and invading the Ukraine. But they should be concerned. It is a global world and Russia’s problems, like China’s, have a way of spreading to everyone else. The means of infection is dollar debt.
The 1998 Asian currency crisis was blamed on what is called the “original sin”, which was borrowing in someone else’s currency. This problem was thought to be a thing of the past. Emerging market debt markets are much more sophisticated these days.
Developing countries and companies can and have sold plenty of debt in their own currencies, but that did not stop them from borrowing in dollars.
Russia, China, Brazil and India all have borrowed heavily in dollars. Russian companies alone have borrowed an estimated $600 billion. But Russia is not alone. According to the Bank for International Settlements there are $2.6 trillion in outstanding debt securities of which three quarters are denominated in dollars. Add to that impressive number the $3.1 trillion loaned by international banks to emerging markets, much of it in dollars.
Corporate leverage in Asia is much higher than it was in 1998, both in absolute terms and relative to GDP. This is an enormous currency mismatch, one that can easily lead to defaults and a currency crisis.
Up to now defaults were farthest from investors’ minds. They are at 1.6% compared to the historical average of 4.2%. But again this disequilibrium has been created by interest rate suppression by central banks. But recently, investor apathy is changing to fear.
Junk bond prices in both the US and Europe are rapidly falling. A high yield ETF (HYLD) has fallen 20% since June. Investors are spending billions to buy insurance with credit index options. The trading volume of credit options has tripled since 2013. The number of ‘puts’ (protection against a weakening credit market) is double the number of calls (protection against a strengthening market).
As always the largest disequilibria exist in China, because large parts of its economy are subject to government control. China’s stock market is still rallying, even though the most recent manufacturing survey (PPI) showed a contraction. The reason for the rally on bad news was the usual one: hopes for more stimuli.
But this is China and stimulus doesn’t always go as planned. Even though the People’s Bank of China reduced interest rates it did not impact the market. The seven-day bond repurchase rate actually rose to 7.55%, the highest since late January. Three-month bank acceptance bills have risen to 5.21% from 4.34% before the rate cut.
Meanwhile, housing prices in China continue to decline along with credit. A major clearinghouse announced it would not accept low rated bonds issued by local governments. This is rather odd because all the players in this local bond market are the government or controlled by it. So it is basically the central government telling weaker local governments that their credit is no good. Without local government borrowing to support infrastructure spending, there is little possibility of the type of stimulus that has driven China’s economic growth.
There is one absolute about markets, they eventually revert to mean, larger the disequilibria, the larger the reversion. The party may go on for a while. It may keep going until the European Central Bank President Mario Draghi finally gets his wish to start full quantitative easing in January. However the extra divergence will be corrected. Given the stress in every economy other than the US, it will probably be soon.
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William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and speaks four languages.)
