UPSIDE DOWN WORLD: An inconvenient truth – emerging markets are rallying

UPSIDE DOWN WORLD: An inconvenient truth – emerging markets are rallying
Emerging markets are rallying.
By Dr Jerome Booth of New Sparta April 25, 2016

“Everyone is entitled to his own opinions, but not his own facts.”

Daniel Patrick Moynihan (attributed)


Emerging markets are rallying. That is a fact. Emerging market bonds have just experienced their largest rally in seven years. The bond market (JPMorgan EMBI GD index) is up over 13% in dollars. The equity market (MSCI EM index) is also up around 7%, easily beating developed market equivalents. Investor inflows into emerging market bond and equity ETFs stand at $4.5bn from the start of the year to mid-April. Short interest is also significantly down.

Assets remain historically cheap and institutional investors are significantly underweight emerging markets, pointing to the potential for more upside. But the fact of this rally is an inconvenient one, hence largely ignored, or seen as an aberration about to reverse. I don’t see it making headlines in the press. What I do see are headlines on the impeachment of Brazil’s president, negativity on China whenever there is an excuse, and further concerns about oil markets.

Corporate bond defaults are now higher in the West than in emerging markets. Emerging market assets remain cheap and developed market assets are still largely in bubble territory, including the dollar.

Global risks do not seem to be improving. The Eurozone, indeed the whole European project, looks ever more likely eventually to implode. The US Federal Reserve has been back-tracking on its rate-raising rhetoric since the beginning of the year due to concerns about the fragility of economic recovery – in part blamed on China and international factors. So why are emerging market assets rallying?

It is axiomatic for many that emerging markets are always riskier than their equivalents in developed markets. Axiomatic but wrong. Emerging markets constitute the part of the global economy not swamped with money-printing in the form of quantitative easing (QE), not in denial about the remaining structural problems in their financial markets, and where sovereign risk is priced in – actually over-priced. 

It is my best guess that as China stabilizes – and it is – the driving dynamic of global markets will shift to central bank reserve managers, and gradual emerging market currency appreciation against the dollar. That would be healthy all round. That it’s gradual is best though. Consequently, as emerging market central banks try to slow currency appreciation by building reserves – Brazil has just done so, for example, following the lower house Presidential impeachment vote – the media looks away. Somehow, it is not as good a story as a reduction of reserves. All the chatter of a few weeks ago about China running out of reserves has stopped as the numbers no longer support the story, but there is not a symmetrical and balancing account of reserve accumulation when they actually increase.

So, sometimes positive emerging market stories are ignored; at other times they get negative spin. One recent story is Saudi Arabia’s issuance of a sovereign bond – surely linked to falling oil revenues, so they must be in trouble, no? Yet an economy of Saudi Arabia’s size should have a significant sovereign bond market, whatever the oil price. Corporate debt issuance is aided by having a stable liquid sovereign curve as a pricing reference. Corporate bonds help finance productive corporate growth but also, by dis-intermediating banks, also help reduce financial sector systemic risks. It is a sign of positive reform: watch this space as I expect a lot more positive economic policy reform from Saudi Arabia.

Divergence ahoj!

International Monetary Fund (IMF) estimates show an increasing divergence ahead between developed and emerging market growth (developed world growth falling to below 2% growth in three years, and emerging markets moving back to above 5%), and that does not take into account the risks of serious growth disruption in the EU or, for that matter, the US. America could easily suffer a growth dip, be it by slipping off its interest rate tightrope, further trade account damage, or via a bond crisis. There is also the risk of another major financial crisis centred where most of the leverage is – again, in Europe and the US 

All this is inconvenient. A way to squirm around inconvenient facts is to doubt their relevance. Are current conditions in emerging markets sustainable or just a short-term aberration? If the world according to standard models and based on standard assumptions doesn’t make sense, then one should eventually question one’s starting assumptions, the axioms – including the idea that EM is always riskier than DM.

There are numerous obstacles preventing such enlightenment however. The world is sufficiently complex that we can never be entirely sure that reality is inconsistent with our axioms. Careful selection of which facts are relevant and which are not is almost universal, and very commonly biased.

Hence what we should focus on is the presence of bias, and we should then try to estimate how significant it is. The clues that something is deeply wrong are as follows. First, we have had a series of financial crises, followed by insufficient reform to give confidence there won’t be more systemic instability. Second, there are big agency problems we can identify. Third, we can point to circular arguments incapable of refutation by evidence – so failing Popper’s definition of science. Most of finance theory falls into this category. Fourth, if we observe that events we know a lot about are reported with a clear bias, then we should worry about the picture of the world we are presented with more broadly.

My conclusion is that the way emerging markets are reported is sensationalist. The way developed markets are reported is reverential. This is a reflection of the deep-seated bias in the way we view the world, which I call Core/Periphery Disease. We have one set of rules for the developed world, and another for emerging markets. We view them differently and the first plank of our outrageous prejudice is that we do so, using different criteria and tools to assess and understand them. The developed world is important and serious, and if markets go up, this typically reflects market wisdom and signals strength. Emerging markets though are peripheral, flimsy and unimportant. If emerging markets rally, then wait a while, for it cannot last.

We do not allow facts to impinge on our deepest prejudices, and even if the world makes no sense to us anymore, in that at least we take comfort.

New Sparta is the private office of Dr Jerome Booth – economist, entrepreneur, investor, commentator and leading expert on emerging markets. New Sparta is majority owner of bne IntelliNews. Follow him on @Jerome_Booth