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Are Emerging Markets Now a Danger?

The domino effect.

John Rekenthaler, 12/13/2013

It's a Theory
Economics is not my thing, although I did once enjoy a money and banking lecture from a former Bank of England official, who worked at the Bank in 1992 when hedge funds, led by George Soros, attempted to take down the English pound. As the official tells it, the Bank was publicly brave in its statements but privately terrified. Soros had it rattled. With good reason, too--because of hedge funds' selling pressure, the Bank was forced to devalue the pound by removing it from the European Exchange Rate Mechanism.

Martin Wolf of Financial Times, on the other hand, understands economics quite well. Unhappily, he has a disturbing thesis. In "The emerging risks of ticking time bonds," Wolf argues that investment managers have replaced banks as the danger zone of finance. Leaning on research from Princeton economist Hyun Song Shin, Wolf worries that the global investment community has become addicted to emerging-markets bonds. And vice versa--emerging countries have become addicted to readily available foreign capital.

This pattern was not healthy when banks were the main source of money to emerging markets. The money spigot from banks does not flow at a consistent rate. Late in economic cycles, when capital is least needed by borrowers, it is most readily available from banks. Conversely, money tightens, sometimes to the point of unavailability, during recessions, when risk avoidance becomes the prime goal. This of course is when capital is most needed.

Wolf fears that the evolution in financing, from banks offering loans (the previous regime) to investment managers purchasing bonds (the current regime), has not improved matters. The lending pattern remains firmly pro-cyclical. Writes Wolf, "As the Fed is expected to tighten, the dollar will rise, prices of dollar bonds will fall and dollar funding will reverse. As the bonds they issued lose value, [emerging-markets] borrowers will be forced to post more domestic currency as collateral. That will squeeze their cash flows and trigger a downturn in corporate spending." The result will be recessions in emerging countries; a "doom loop" in Wolf's words.

In such an event, the doom loop would surely also swallow the stocks of developing markets. They likely would not decline as far, but emerging markets have become so large and so connected with other economies that there would be few places to hide with a stock portfolio.

This thesis worries me twice over. First, Wolf is not one to cry his name. If James Grant, for example, writes that terrible things are on the horizon, I won't fuss. Grant is by nature a pessimist who constantly foresees a future that is more dismal than the future that actually arrives. Wolf, on the other hand, is parsimonious with his predictions of doom. For example, when Wolf reviewed Nouriel Roubini's early 2008 forecast of a collapse in the housing market rending the financial sector, he concluded that Roubini was "excessively pessimistic."

Second, with the recent economic strengthening and the Federal Reserve pondering how to end its program of quantitative easing (QE), Wolf's trigger point may come sooner rather than later. Yes, ending QE is not the same as raising short-term rates, but it's a step in that direction. The next step from there would be the higher rates that Wolf believes will begin the domino effect.

Those things said, Wolf's theory does require a fair amount of speculation. As Wolf acknowledges, global asset flows are difficult to track. Returns on emerging-markets bonds and stocks, of course, are straightforward to gather. But as asset flows from investment managers are not, it's all a bit of a guess as to the relationship between the two.

is vice president of research for Morningstar.

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