A Gathering Storm, Part II: Hurricane Shutters

"I'm boarding up the windows... Locking up my heart... It's like every time the wind blows... I feel it tearing us apart"

- Bridgit Mendler in "Hurricane"

Hurricane warning

Growing up in Parkland, Florida, I remember how thrilling it was to turn on the TV in the morning and learn that my town was under a "hurricane warning." Yes!! No school!! Smiling ear to ear, I would lay down, close my eyes, and prepare for a daylong vacation. The excitement would usually last about 10 minutes, until Mom knocked down my door, forced me out of bed, and started handing me pieces of industrial sheet metal known as hurricane shutters. So much for vacation.

Today, one year after Hurricane Bernanke and the Taper Tantrum Tornadoes (sounds like a rock band) pummeled Bond Land, are emerging markets in general, and the "Fragile Five" in particular, better-prepared for another storm? Have policymakers fortified their economic defenses by reducing reliance on external borrowing, consolidating fiscal accounts, and increasing foreign reserve buffers... or are they still hiding under the covers, waiting for mom (Janet Yellen) to knock down the door?

To answer this question, we examine three factors -- current account balances, fiscal balances, and reserve positions, the glass windows and sliding doors of emerging markets. Just like well-positioned hurricane shutters guard your home against hurricanes, strong internal and external balances insulate economies from macroeconomic shocks. To be fair, other factors, including economic growth rates, currency valuations, financial account composition, and interest rate flexibility also matter, but these three are the most important considerations for investors in EM debt.

Current account

An EM that runs a current account deficit is like a couple that buys a glass house overlooking the Atlantic Ocean -- great when the weather's nice, dangerous when it turns ugly. Current account balances measure the degree to which an economy relies on foreign capital. When interest rates in the US rise, making Treasuries more attractive, countries with current account deficits may have trouble retaining foreign capital, as their financial assets become relatively less attractive. Normally, this process prompts central banks in EM countries to raise rates, deploy foreign reserves, or restrict capital outflows -- all bad outcomes for investors.

The chart below shows the IMF's most recent estimates of current account balances from 2012-2019 for the Fragile Five economies. As you can see, current account deficits in four of the five countries either improved or stabilized over the last 12 months. Furthermore, the IMF estimates that these balances will remain stable over the next five years. In absolute terms, Turkey and South Africa appear the most vulnerable, but ever their external positions are expected to improve.  

Source: IMF World Economic Outlook Database

Fiscal account

We in America are all-too-familiar with fiscal deficits. Governments that spend more than they take in through taxes must borrow the difference. Unlike EM governments, we in the US benefit from having the global reserve currency, which creates enormous demand for our debt. In developing countries, where savings are scarce, fiscal deficits are financed largely through external borrowing. Hence, when a country consistently runs fiscal deficits, its vulnerability to capital flow reversals increases.

The problem is that reducing a deficit, either through lower spending or higher taxes, is bad politics in any language. It's even worse when economic growth is slowing, and harder still in light of legacy budgetary commitments. But the data highlight a promising trend. Only South Africa has experienced a worsening fiscal balance, and even there, analysts are becoming more optimistic about their outlook. India appears the most vulnerable in the group, with a structural deficit equal to 6 percent of GDP, but, as the chart above shows, it's also the country that depends the least on external financing.

Source: IMF World Economic Outlook Database

Reserves

Red beans, peanut butter, and Saltines; the hallmarks of a well-prepared Floridian pantry. I love them all, but most people consider these items "emergency supplies" and keep them only in case power disappears and supermarkets close.

Foreign reserves are the red beans of economic management. Reserves are important for three reasons. First, they serve as ammunition for central banks to prevent currency crises. Second, they ensure that countries can continue to import essential goods without undergoing a painful devaluation. And third, they enable governments to avoid defaulting on dollar-denominated debts.

Central banks throughout the emerging world recognize the importance of reserve buffers extremely well, having witnessed (or experienced) the chaos that occurs when countries exhaust their reserves and need to devalue, default, and/or accept IMF assistance. Moreover, they see the storm coming. According to the Wall Street Journal, EM central banks are already managing reserve portfolios with caution ahead of policy normalization in the US.

This chart shows that reserve positions have remained mostly stable throughout the Fragile Five. This makes sense because, over the same period, these countries relied on interest rates to stem capital outflows. Brazil raised its 9-month borrowing rate an astonishing 230 basis points between June and December 2013. Turkey hiked its 3-month borrowing rate 120 basis points over the same period.

These moves inspire confidence in EM central bankers, but they also underscore an important point for fixed income investors. If the taper tantrum is any indication, central banks are more likely to raise rates than expend reserves to stabilize their exchange rates. This makes duration (or interest rate risk) less attractive and encourages investors to trade into shorter-maturity instruments.

Source: Capital IQ

Are we ready?

Even after covering every single window and sliding door around our house, we could never be sure that the shutters would protect us from Mother Nature. But we had to stop somewhere. Likewise, EM policymakers and investors cannot fully anticipate what sort of chaos Mother Yellen may unleash.

But based on our analysis above, the underlying structure looks stronger and more resilient than it did a year ago. External borrowing has improved or stabilized. Fiscal balances are on the right path. Reserves remain solid. Overall, economies appear less vulnerable today than on May 21, 2013, when Hurricane Bernanke made landfall, sending reverberations through the markets.

Weaknesses definitely remain. None of the charts looks great. Twin deficits -- current account and fiscal account -- are still the Achilles' Heel of the entire EM complex, and nobody knows what absolute level of internal or external indebtedness could trigger a sell-off that would send yields higher and exchange rates lower. These are the risks we take when reaching for returns in faraway places.

One more trip to Wal-Mart

No matter how many jars of peanut butter you have socked away, it's never a bad idea to make one more trip to Wal-Mart before the storm hits. If you're looking for ways to protect your portfolio from another nightmare scenario, here are some possible actions:

1. Buy EM index options: It's not a perfect hedge, but you can buy options that should perform well if and when the EM complex gets hit. One possibility is to buy out-of-the-money put options on an emerging markets equity index, such as EEM. With the VIX at historically low levels, options are relatively cheap. The June 2015 $33.00 put currently sells for $0.75. 
2. Buy single-country index options: Employing the same strategy through single-country ETFs (such as TUR for Turkey or EWZ for Brazil) may seem more sophisticated, but be careful -- options on single-country EM indexes are relatively illiquid, leading to wider bid-ask spreads. It's also difficult to find long-term options on these indexes, so you need to keep rolling them over.
3. Make sure you have quality names: Not all EMs are created equal, as the preceding analysis shows, and different funds have different levels of exposure to various countries. Make sure you understand these exposures and feel comfortable with the countries whose sovereign and corporate debt are held in your portfolio.

Life's a beach

Amid all this talk about risks and hedging, don't forget about the incredible secular growth story in EM. In a low-yield, low-growth world, these countries provide some amazing opportunities to generate returns. Nobody moves to Florida for the hurricanes; they move for the beach! But when Hurricane Season rolls around and storm clouds start muscling out the sun, make sure you put on the shutters.

Thanks for reading! Feel free to leave a comment.