Bad Enough the Last Time Around
I’m getting that old feeling, and it has nothing to do with the 1930s pop song immortalized by Jazz great Chet Baker’s signature cover version.
I refer instead to the sustained blood bath in emerging market debt that has driven bond yields skyward and threatens a far less melodious reprise of its own: a repeat of the Asian currency collapse, only with global reach.
Back in the 1990s, dollar-denominated, evolving-nation debt was fixed-incomes’ junk food of choice, particularly in the Far East. Booming economies like South Korea and Thailand enthusiastically securitized their public and corporate debt and traders were just as eager to buy it. Then, as now, both sides convinced themselves that low interest rates, like any other bill of goods, was an inexhaustible gift even for countries whose currencies were linked to the US dollar.
When the bubble burst in 1997, it did so with seismic effect. As currencies collapsed against the dollar, issuers’ borrowing costs surged along with local interest rates and bond yields. To defend their currencies, they burned through months of foreign exchange reserves. Stock markets plunged. Uncertainty begat inflation, along with hording and black market activity. There were runs on ATMs as banking systems, the economy’s lifeblood, turned anemic.
Asian capitals, once among the world’s most dynamic cities, became ghost towns overnight. Wrapping up a series of emergency meetings in Bangkok, a team of advisors from the International Monetary Fund wryly noted that it was on time for all its engagements because the city’s usually jammed streets were empty.
Fortunately, most of the countries laid low by the crisis learned their lessons. They replenished their hard-currency stocks and floated their currencies, broadened their fixed-income markets by promoting insurance plans, pension funds and home-loans and developed local-currency sovereign and corporate bonds. Not only that, as developed nations have ramped their debt-to-GDP ratio to 100% thanks to a decade of quantitative easing, emerging markets have held their leverage ratio to pre-2008 levels.
The problem – as recent events make abundantly clear – is that there are enough first and repeat offenders to guarantee us at least a few emerging-market meltdowns in our lifetimes. The vital signs were there for all to see, beginning with the sheer volume of products in a market where traders had to compete for yield, with central banks scooping up trillions of dollars of bonds for their own account. Since the start of 2016, Bloomberg reports, investors purchased $1.5 trillion worth of new debt issues from emerging-market governments and corporates, most of which was dollar-denominated.
This at a time when the Fed was mulling not whether it would increase interest rates, but how.
Then there was the question of issuers’ creditworthiness in the face of mounting debt loads, weakening terms of trade, stalling growth and, in some countries, political risk. (Or, as is the case in Turkey, executive malpractice.) Toss in a rising dollar, as Harvard professor Carman Reinhart declared last month, and you have a toxic brew more serious than the 2008 crisis and 2013 taper tantrum, when equities endured routs of 64% and 17% respectively.
(In case you’re wondering, no one here at Anfield was surprised by this denouement. We have no problem with emerging markets per se – love the food, dig the music – but in our view the yields were not worth the exposure and we managed our portfolios accordingly.)
I am an optimist who believes self-enlightenment is the best hedge against market unpleasantries. CreditSights Ltd., for example, issued a note last week that compared degrees of overleverage between Argentina and Turkey. Both countries suffer from low reserves relative to short-term debt and sizeable current account deficits. However, while the heart of Argentina debt problems is sovereign, Turkey’s is largely external borrowing by its banks and businesses. On a relative basis, that makes Argentina the hard case and Turkey the long-term play. “We have little doubt that a prolonged crisis in Turkey would do damage to its banks and corporates,” according to CreditSights, “but at a sovereign level, we continue to view Argentina as notably weaker.”
Meanwhile, Washington appears to be on track for qualitative “tightening,” a process that may destabilize dollar-centric securities. Last month, Fed Chairman Jay Powell warned that “the normalization of monetary policy in advanced economies should continue to prove manageable for [emerging markets],” adding they “should not be surprised by our actions if the economy evolves in line with expectations.”
We don’t disparage Powell’s hard line. In fact, we’ve been calling for higher interest rates for the last several years for the sake of pre-empting the very chaos that now grips emerging markets. (Ahem … once more ahead of the curve.)
Indeed, compare Powell’s resolute stance to the equivocation nearly two decades ago to his predecessor, Alan Greenspan, with regard to the Asian crisis. Privately, we understand Greenspan said he wanted to raise interest rates in 1997 but the currency crisis derailed his plan. The result, some believe, was excessive liquidity that inflated the tech stock bubble and subsequent crash of 2000.