Korean KOSPI - the bubble market has burst

Sometimes the bubble burst will sneak up on you even if it is in plain sight. The Korean KOSPI index is down over 44% in approximately 40 days, with over 300,000 individual leveraged accounts liquidated and over 1.2 million accounts receiving margin calls this month. 

The index was about 45-50 percent information technology, with the largest exposure in Samsung and SK Hynix. The problem for the US is that the IT sector is globally integrated, so events in South Korea are not just a local event. Clearly, there has already been some spillover, but the real fear is a contagion that would require valuations for this sector around the globe to be reset. 

You can already see the spillover when we compare the one-month returns.

 

Categorize EM before running analysis

There are several ways of classifying emerging markets. JP Morgan Wealth Management has looked at a system of three key factors: economies with a large private sector which focuses on making money in a competitive environment; economies where companies generate high earnings per share; and economies with strong and growing export industries. The likelihood of success should be higher with holding country exposure in these economies. It does not guarantee success, but these are the countries which have a good environment for generating higher returns. There are five countries in this intersection. Four are in Asia and one is our southern neighbor. More focus should be spent on studying the dynamics of these countries. 

The weak link between EM returns and growth

Focusing on macro relationship and how they can be exploited in a model, we have looked at the relationship between growth and equity returns. We have been disappointed by the fact that the link has varied significantly across countries. In places like the US and Japan, equity returns have far exceeded nominal GDP over the last 15 years. In many other countries, GDP growth have exceeded equity returns. These numbers will be impacted by the percentage of companies within a country that have global business, but there is the impression or assumption that there should generally be a positive link between GDP and returns especially in the long run. Simple data does not suggest a link and deeper analysis is necessary. 

The link between earnings, market returns, and GDP is not strong

One of the key problems with macro equity investing is that the link between earnings growth, market return and GDP growth are not often in lockstep. The chart shows that in the US earnings and market growth has been significantly higher than GDP growth, yet in many countries earnings and market growth have not been able to keep up with GDP growth. The link between GDP forecasting and market and earnings forecasting is not strong. You can be a great macro forecaster but that does not translate into making money in the equity markets.

The developed world is shrinking! Cannot trade on this but it is key investment theme

 

Demographics has been viewed as destiny, yet you would not want to use it as a trading signal in the short run. Following population trends would have not worked because it would have put too much emphasis on EM equities over the last decade; nevertheless, these demographic trends should not be ignored, and they produce some key pressures on all markets. Demographics, however, are not just about investing in the growing problem. It is also about investing in developed market companies that service these growing population regions.  They are many ways to play this theme.

Sovereign risk tracker - limited financial risk

The CFR sovereign risk tracker follows a number of key features associated with sovereign risk. Risk is concentrated in those stayed that have failed politics and have been unable to solve their fiscal problems. There does not seem to be a significant amount of risk associated with higher real rates with the dollar. Slow growth tied with higher rates was supposed to be a mix harming many EM countries. This narrative has no played out as expected.

EM risk and points of inflection from a Fed rate rise

 

We classify current EM risks as points of inflection; the issues that should be closely watched and exacerbated by a hawkish Fed.

1. China is the big elephant in the room when discussing EM. It is hard to even classify China as EM given its size; however, country classification is a different question. The global economy needs a growth driver - a large economy or group that will lift other countries. US monetary policy is working in the opposite direction. The same can be said for the EU, so the focus is on China which has not tightened monetary policy and is attempting to boost growth; however, with a major real estate problem and rolling lockdowns, China has little ability to drive the world economy. In fact, CNY is closing in on 5-year lows.

 

2. The oil shock has sent massive capital flows to the Middle East. Oil exporters are in a great economic shape, but it is less clear that this money will be reversed into global investments that boost other parts of the world. Oil prices have pushed through $80 per barrel, so the oil flow excesses are slowing. 

3. Current account deficits are not as large as past recession periods, and foreign currency reserve coverage is greater for most countries. This minimizes crisis risk, but there are still some countries that will be crisis hotspots even in the EU. 

4. EM bond spreads have widened already and have some distance from US high yield, so there is less risk of a future EM bond shock. However, there is still room for EM HY yields to reach double digit levels.

5. Geopolitical risk both in Eastern Europe and Asia is still high. Lengthened hostilities in Ukraine are more likely to lead to extreme action to break any deadlock. The spillover effect across Europe is high. The China-Taiwan issues have simmered, but there is still high risk which will spillover the surrounding countries. 

6. The Brazil general election on October 2 and the Presidential runoff on October 30 has cast a shadow over the largest economy in Latin America and the president will impact the investment climate. The shift in politics across the continent places downward pressure across capital markets. 

7. The overall decline in international trade places downward on many of the economies that have depended on globalization. While EM domestic growth has surged, economies are still dependent on G7 growth.

EM risk from Fed tightening - Is this time different? Yes, but ....

 

The hawkish Fed policy is bad for EM financial markets, but there has not been an EM financial crisis for some time. EM markets are in much better shape than in the 1990's, yet that does not mean they will be immune to a significant rate shock especially if the purpose of the rate rise is to cut aggregate demand. There may be opportunities with holding EMB bonds, but we may not be there yet as the market reprices global interest rate risk. See "Emerging Markets and the Hiking Cycle: This Time, Really, May be Different" for this more optimistic perspective. 

The EM equity and bond indices have changed significantly over the last 20 years. The EM bond benchmark is much more diversified with less exposure to Latin America where past crises have been centered.  The MSCI EM equity index has moved to greater concentration in Asia, but these countries have stronger foreign reserves to protect form any currency crisis. The sector allocations have also changed over the last 20 years. EM is less dependent on energy and materials and more diversified across consumer companies and IT. This does not mean less sensitivity to a global slowdown. It does mean the points of risk are different.

Gross public debt has increased, but the growth has come from domestic public debt and not external public debt. FX reserves as percentage of GDP have increased significantly and are almost double levels from 2001. Greater reserves provide countries greater protection for their currencies if there is a crisis. 

We are worried about EM exposures. Fed rate increases have a spillover across global financial markets; however, EM financial markets may be more resilient than the environment of the 1990's.

The hawkish Fed - Nothing good for emerging markets

The Fed's hawkish policies of raising rates will have more than just an impact on the US economy it will impact emerging markets. We have already seen a significant divergence between EM and US equities as measured by the difference between SPY and EEM. There has historically been a strong negative link between increases in the Fed Funds rate and EM, but it looks as though this relationship has not been as strong over the last two decades. Work from the Fed shows there is a reason for this difference in sensitivity. See "Are Rising U.S. Interest Rates Destabilizing for Emerging Market Economies?".

The analysis shows that there is a difference in the EM response based the reason for the rate rise. If rates are increasing because there is higher economic growth, there will be limited impact on EM. On the other hand, if the rate increase is caused by a hawkish Fed policy to combat inflation, there will be a strong negative impact. 

Growth news is different than monetary news. Growth news occurs when SPX index returns and 10-year Treasury yields move in the same direction after a FOMC or employment announcement. The FOMC announcement or employment data conveys monetary news if equity returns and Treasury yields move in opposite directions. Based on this classification, it can be determined what will be the reaction in EM through looking at panel data for a large set of EM countries.

If the Fed is trying to cut aggregate demand, there will be a spillover effect to other countries. This current environment is more like the early 1980's than anything seen in the last two decades. While the test is over short horizons, it provides investors some insight on what to expect around the globe. This time will not be good for EM investors. 

 

Emerging markets equities - Macro or fundamental factors as drivers?

Are emerging markets equity returns driven by economic growth? On a simple level, there should be a link between growth and equity returns for a country, yet nothing is simple. The behavior and valuation of firms is not  tied to economic growth as described in the paper, "What matters more for emerging markets investors: Economic growth or EPS growth?" The figure show that for both developed and emerging markets, real stock returns are not correlated with GDP growth. The drivers of stock returns will be tied to the fundamentals of firms within the country index.

The long-term relationship between fundamentals like EPS and DPS are positively correlated while the correlations with per capita GDP are not significant. The long-term fundamentals are the main driver for country equity returns.

However, country stock returns may not be immune to changes in the business cycle and short-term growth. It is important to link macro dynamics to firm fundamentals which will drive conditional returns in the short-run.

Global food and commodity fall-out from the Ukraine-Russia War is significant

 

The global commodity and food fall-out from the Ukraine-Russia War is significant. G20 countries will feel the impact with higher energy costs and cost-push inflation, but emerging markets and frontier economies may face a real food shortage. Africa is especially dependent on Russia and Ukraine grain. If that supply is withheld from the market or if grains in the Ukraine are not planted and harvested, the shortfall must be made up from other sources. Yet, those sources may not exist. The last time we had a grain price shock in the Middle East sporadic food riots existed.

The same war disruption problem, albeit to a lesser extent, exists for metals and energies in other countries; however, the gravity of a food shortage dwarfs and shortage in metals or energy.

IMF global growth forecasts are being lowered. At the same time, financial conditions are tightening around the world. There are no easy solutions and investors should be prepared for monetary policy reversals if real growth is truly affected. We are already seeing governments discuss and plan for policies which subsidize the higher gasoline prices.

Any global food shortages will cause a flight to safety and will dampen any risk-on thinking that may try to assert itself in current markets. 

Hanke measures - Inflation is everywhere

The developed world is currently crazy about inflation but take a close look at some of the emerging and frontier market inflation numbers. Inflation is out of control as measured by free-market exchange rates from the Steve Hanke's website, Hanke's Inflation Satellite. 

Showing these numbers does not diminish the problem in the US or other DM markets, but it does show that prices can get out of control if there are not strong institutions and governments that have the desire to control inflation excesses.

Are investors getting EM exposure or just China with some other EM risk in their equity benchmark?

Many equity investors will hold or benchmark their EM exposure with the MSCI emerging market equity index, but a close look will show that the index has changed radically through time. The top country exposure has switched several times through the decades, and we now have an index which is dominated by China. 

Given that China stocks have been hit hard from slower economic growth, geopolitical issues, changes in government regulation, and a growing real estate crisis starting with Evergrande, the EM benchmark has also been driven lower. In the last year, EEM has shown a decline but the EM index less China EMXC has gained 14 percent. 

A Goldman Sachs report shows the dominance of China in the MSCI index. China dominates in a way that has never been seen before and is the largest single country share in the history of the index. China is the second largest equity market globally and its weight in the MSCI EM index has doubled in the last five years. 

Not only is China a large weight in the index, but it has a low correlation with other EM stocks. The industry mix is different, and the drivers of return are different from other components of the EM equity index. This problem also exists for EM bond indices. 

China is an outlier from the rest of the EM market. It is an outlier with other developed markets, yet it cannot be ignored. Every investor must have a China opinion. Every investor must now think about EM investing with and without China. 

Debt sustainability - this issue can again become important in the post-recovery period

Debt levels have exploded around the global. The growth has been most dramatic in developed countries like the US, but this debt explosion has been occurring across most countries. In the case of the US, the central bank has been a strong buyer of Treasuries, so the debt is not being held by private investors. Debt has been exchanged for reserves. There is a growing view through Modern Monetary Theory (MMT) that the monetizing debt is not a problem and if it becomes a problem through higher inflation, it can be solved through quick reversal of policies. 

Nevertheless, all countries may not be able to engage in the current debt policy extremes of the US nor may the US at some point. For most countries, debt sustainability will be an economic problem if certain extremes are reached. In the pre-MMT world there was a clear focus on debt through the strong arguments in This Time is Different: Eight Centuries of Financial Folly by Reinhart and Rogoff. However, any current emphasis on austerity has been relegated to a policy closet. Still, it is important for investors to score countries on this critical issue and be aware that it can serve as a catalyst for market sell-offs in specific countries. 

Country debt sustainability can be measured through a scorecard. Here are some of the most commonly used factors for assessing debt vulnerability:

1. Debt/GDP - As the debt to GDP exceeds 100% there is greater likelihood of a slowdown in growth based on the cost of maintaining the debt.

2. Primary balance (government revenue - expenses and interest costs) - Sustained negative balances especially during periods of robust growth calls into question the ability to pay principle.

3. Interest rate versus GDP growth - When rates exceed GDP growth, the cost of debt will not be able to be maintained.

4. Weighted average maturity of debt - More short-term debt increases the risk of rolling over principle when the debt matures.

5. Interest/revenue ratio - An increasing ratio will mean that other government expenses will be crowded-out by interest payments.

These factors must be weighed against the governance of the country, policy uncertainty, and the overall demographics which affect ability to pay. The likelihood debt will be a problem is also affected by the financial stability of the country and the external imbalances current account imbalances and foreign indebtedness. 

While there may not be an immediate debt crisis, tracking country difference will pay-off. There are limits to country borrowing, and those limits, if reached, can lead to large currency declines, rising rates, and equity selloffs over a short time period.

Country risk and global equity trading - Emerging markets still have a strong local focus

Country selection still matters when decomposing risk for emerging equity markets, not so much for developed markets. Some updated charts on the variance decomposition between developed and emerging markets shows that EM markets are still not fully integrated with DM markets. Country choice and awareness are still important.

For developed markets, market beta followed by industry risk are the two most important components of variance decomposition. Country risk has shrunk over the last three decades. DM markets have become more deeply integrated. A large corporation in the UK or Switzerland and not much different than a US firm in the same industry. 

While there is a similar trend toward integration in emerging markets, the movement is much less pronounced. Market risk and country risk explain 90% of the variance with the relative importance respectively 2/3rds and 1/3rd. Focusing on country risk is still important. Of course, there is variation on geography or region integration, but the country macro environment for EM matters. 

EM investing should be integrated across equity, bond, and currency markets based on the macro environment. Capital flows into EM equities will be sensitive to macro events with sensitivity associated with overall trade and financial integration. The need for a global/local macro holistic approach is greater than developed markets that will have a stronger focus on global macro market beta considerations. 

What do you get versus what you may want with EM ETF's

If you buy the most liquid equity emerging markets ETF (EEM), you will be purchasing an Asian-centric portfolio with over 1/3 of your exposure in China and over 60% in just three countries, China, Taiwan, and South Korea, and over 80 percent in Asia.  

On the other hand, if you buy the leading emerging market bond ETF (EMB), you are holding a very different regional exposure. An investor will hold 4.5 times as much LATAM and less than 1/5 of the exposure in Asia. There is more diversification of country exposure in the bond ETF, but the country mix is very different from the equity ETF. 

Both ETFs reflect the exposures in their respective equity and benchmarks. There is no hiding what the ETF will represent. There is complete transparency with the exposures, yet retail flows may not be aware of the regional bets taken. Holding a mix of equity and bond EM ETF or benchmark exposures give very different geographical exposure. The bond benchmark will grow with the amount of debt being issued. More leverage will increase EM bond exposure. More equity growth with increase the country equity exposures. 

The issue of what you are buying with these ETF's is not limited to regions. In the case of EMB, there is a mix between investment grade and high yield, respectively 60% and 40%. Most of what is being purchased is sovereign bonds and not corporates. For equity investors, buying EEM is not an EM commodity play given the diversification of sectors. 

Given the mix of assets, any quick purchases may generate surprises for investors who don't think through the portfolio exposures gained.  

DM and EM equity market differences and commonality

The Norwegian Ministry of a Finance commissioned a study of global equity markets from MSCI, “Selected Geographical Issues in the Global Listed Equity Market”. This exhaustive research study on global equity markets could be better called, “The differences between developed and emerging equity markets”. This is valuable reading for understanding the return differences and similarities between developed and emerging markets.

The world is becoming more global and emerging markets are a more important part of equity markets, yet their representation is still lower than market capitalization and GDP would suggest. Investors need to have an EM opinion and have to think about global economic impacts on equity valuations. Trade wars have had a significant impact on equities because more global corporate sales comes from outside a stock's home country.

Returns are higher in EM markets but so are volatilities. Emerging markets are more diverse than developed markets. EM equities will be correlated with common factors like a financial crisis, but if an investor wants more diversification benefit, it will come from holding EM markets and not diversifying across DM markets.

The world equity markets can be divided into regions include North America, EMEA, the Pacific, and EM. These regions will show common return performance dominated by their largest country equity market. Still, market fundamentals, whether price to book, price to earnings, dividend yield, or return on equity, will generally move together. 

The EM sector is getting larger for two reasons, economic growth in EM countries have been increasing relative to DM so EM represent a greater share of global GDP and the fact that more countries and names are being added to the EM index. EM markets are more sensitive to economic growth especially with respect to the downside. There is a similar pattern of sensitivity of DM and EM markets to inflation.

EM stocks are also more sensitive to currency changes. The increase in the dollar has been an important drag on EM overall returns. The currency impact on DM equities is far less dramatic. It is necessary to have a currency view when investing with EM equities.

The equity risk premium is actually well-defined across countries with liquidity, governance, and size having additional impact on explaining this risk premia.

To be an effective global equity investor, someone needs to understand the similarities and differences across geographical regions, as well as between DM and EM markets. There is much commonality which leads to high correlations, but there are also enough differences to have it worth holding a diversified global equity basket.