A Gathering Storm in Emerging Markets?

"Oh, my G-d, I feel it in the air... Telephone wires above are sizzling like a snare... Honey, I'm on fire, I feel it everywhere, Nothing scares me anymore..."

- Lana Del Rey

Summertime sadness

Summertime storms are a tradition in Washington, DC so the one that began on May 22, 2013 came right on schedule. Ominous clouds opened when then-chairman Ben Bernanke warned the Joint Economic Committee of Congress that the FOMC could soon "take a step down in our pace of purchases." Over the next few weeks, the storm -- or "tantrum" -- that started on Capitol Hill left bond investors around the world drenched in red ink. Concerns over rising rates became a self-fulfilling prophecy, with investors selling bonds from Argentina to New Zealand. Traders likened the experience to 1994, when Alan Greenspan announced a surprise rate hike, throwing a lightning bolt into fixed income markets.

At the dawn of 2014, with a new Fed chair and widespread optimism about the US economy, virtually every Wall Street forecaster predicted rates to continue moving higher. Great American companies like Netflix and Facebook were back in vogue, and many expected the "Great Rotation" from bonds into equities to begin. What could go wrong?

Risk reversal

Well, seven months into 2014, rates have actually fallen (although equities continue to climb). Today, the 10-year Treasury yields 2.63 percent, almost 40 basis points less than at the beginning of the year. The surprise decline in rates reflects a combination of fundamental and technical forces that have increased the relative attractiveness of Treasuries. On the fundamentals, investors have started questioning the US economic recovery, as capital spending, retail sales, and other macro variables remain weak. Technically, Treasuries are in higher demand and shorter supply, which puts even more upward pressure on prices and downward pressure on yields. Last but not least, Chair Yellen's commitment to keep short-term rates low for "a considerable period" also matters.

Investors have responded to these developments in a predictable -- albeit worrisome -- way. This year has seen savers migrate back into risk assets, including corporate bonds, asset-backed securities, and emerging market (EM) bonds. Flows have sent spreads, which measure the risk premium investors demand, to levels not seen since 2007. No wonder Chair Yellen commented at her June 18 press conference that these developments were "a concern to me and to the committee."

    Source: Federal Reserve Bank of St. Louis

Emerging Market (EM) bonds have also benefited from the rally in risk assets. Spreads are back to November 2007 levels, and flows into EM bond funds remain strong. Assets under management at EMLC, an ETF that tracks local EM debt, have surged 10 percent since Treasury yields started to fall in early April. EM government bonds have delivered the best year-to-date return among sovereign fixed income, making them look even more attractive.

Remember when...

It's easy to forget about the bad times and ignore the risks when returns look so good, but even the shortest-sighted investor should remember how vulnerable emerging markets can be to macroeconomic shocks. The taper tantrum sent EMLC into a tailspin, slashing its value by 14 percent last year. EM equities fell, too, with VWO, the biggest ETF in the sector, losing 9.5 percent in 2013.

The bloodshed evoked memories of the late-90s, when troubles in one EM infected other EMs for no other reason than they both started with the letter "E." Troubles in Thailand ignited a firestorm across Southeast Asia, devastating economies that appeared relatively (albeit not completely) stable. The same indiscriminate selling occurred to some extent this time around. But the sell-off did hurt weak economies more than strong ones, suggesting that some EMs were structurally weaker than others.

Morgan Stanley coined the term "the Fragile Five" to describe five EM countries - Brazil, Indonesia, India, South Africa, and Turkey - that were especially vulnerable to reversals in capital flows, due to persistently large current account deficits and/or inflexible exchange rates. If interest rates were to rise in the US, the argument went, capital would leave the Fragile Five and return home, causing a downward spiral of exchange rates, growth rates, and asset values. Get out now.

The conversation turned from the symptoms of macroeconomic weakness to the underlying causes. Questions around institutions, competitiveness, reserve positions, and currency flexibility prevailed, compelling investors to consider the possibility that certain EM countries had deeper vulnerabilities than others, and were therefore more susceptible to capital flow reversals. The taper had simply exposed these weaknesses the same way the tide reveals who's been swimming naked.

Back to the future

Today, with all the speculation about the timing of rate hikes in the US, investors need to determine whether it's time to take their money and run on EM bonds. The decision matters greatly to retail investors. Merrill Lynch controls 20 percent of EMLC, and the asset management arms of Wells Fargo and UBS own 25 percent of EMB, another popular bond fund, according to Capital IQ. Check your account; you may be surprised.

The first question we need to answer is: could the "hike heebies" trigger a widespread and automatic sell-off in EM bonds. Some think so. A new paper argues that the reversal of accommodative monetary policy by the Fed, no matter how well-telegraphed, would more probably lead to an increase in volatility than not. Moreover, economists at the IMF note that one reason EM rates spiked in 2013 was that spreads had gotten so low. Today, with spreads on EM bonds even tighter than last year, the entire complex could be vulnerable to a rise in short-term rates.

Others believe the market response will be more nuanced. Communication between the Fed and the markets, they argue, has improved substantially under Chair Yellen, who cut her teeth managing the Fed's communication strategy under Bernanke. Market expectations for the first rate hike have remained stable since April (according to Fed Funds futures), reflecting the success of forward guidance from the Fed. As an asset class, these folks believe, EM bonds have priced in rate hikes.

Same same... or different?

If you subscribe to the first set of arguments, your options are clear: take some money off the table and/or protect your positions through options. With the VIX at rock-bottom levels, there's nothing wrong with buying puts on VWO or other assets likely to be crushed in a turbulent scenario.

But if you think the sell-off (if it occurs at all) could be more nuanced this time around, the next question is: which EMs are your best bets? As the IMF notes, differences in macroeconomic conditions mattered immensely last year. The chart below shows that countries with weaker fundamentals (high inflation and large current account deficits) suffered the worst sell-offs amid the taper tantrum.

Source: International Monetary Fund

Judgment day

Hopeful analysts implored policymakers in EM to think of the taper tantrum as a "teachable moment" - a painful reminder of the need to reform the structural weaknesses responsible for gaping imbalances and persistently high inflation. Nobody expected these reforms to be easy, but investors hoped that the turmoil following the taper tantrum would motivate officials to make tough choices.

"Time has come today," said the Chambers Brothers. Which EMs have been stocking up on canned food, flashlights, and batteries... and which ones look destined to suffer from the next hurricane?

In my next post, I will seek to answer these questions by focusing on the external balances and international inflation/growth dynamics of the emerging market economies. My results will form the foundation of my recommendation regarding portfolio strategy going forward.

Thanks for reading, and feel free to leave a comment!