Maybe this is not the time to try to think through the medium-term outlook of an asset class (but it’s easier to resume writing on this than to comment on the 90% tax on bonuses…). But I think one of the most interesting questions to think about is which countries will fare better than others. In other words, as the dust settles, differentiation will begin, and the distribution of spreads will widen, some EM currencies will revert to their FX appreciating trends leaving pears behind, and local interest rates will only come off further in countries with strong aggregate balance sheets.
This all sounds very fine, but if we are having a hard time thinking through G7 phenomena, how can we predict who will outperform? I do not intend to pin point specific countries, but I do think EM will become a bifurcated asset class. In other words, I think the stylized economic and political phenomena that made it a group had started to fizzle before this crisis. This crisis is emphasizing the differences.
Not to go on a historical tangent, but post the 1982 default en masse episode and for about 20 years EM had a few very strong set of unifying common features. Most countries exhibited persistent fiscal deficits, usually financed by the inflation tax, making currencies at most the means of exchange, with hyperinflation episodes here and there. Balance of payments crises were a common occurrence, many times coupled with banking crises. Banking systems were mostly financing fiscal deficits, and monetary aggregates were volatile but always very low relative to any developed country. Economies were fairly closed most of the time, over-regulated and inefficient. Relative prices unstable, providing volatile incentives/signals on which sectors made sense to invest in.
During the 1990s many of these economic diseases started to be cured, most importantly the over-regulation and trade closeness (reforms). The current decade has seen the recovery of fiscal discipline in some, and the ensuing appearance of strong local currencies and debt markets.
But the important issue here, more than providing a reckoning of the 90s and the current decade, is that now there seems to be two sets of countries (being slightly simplistic for the sake of the argument). There is a group of countries with credible currencies, large and growing local markets (with curves beyond the 10y tenor, and liquid swaps markets), and most recently the unprecedented capacity to think and announce counter-cyclical policies a la G7. Those countries had taken advantage of the commodities windfall to work on their sovereign liabilities such that FX exposure has fallen significantly, reduced and replaced by local debt. Moreover, some have become net creditors of G7 due to their large reserve accumulation. Finally, and maybe more importantly, this crisis has not shaken the consensus around a few important core economic principles, which are allowing the convergence to G7 standards of living (and capital/labor ratios).
On the other side, there is a group of countries that are suffering or about to suffer again the same economic diseases they had during the 1980s. More importantly, the policy stance is actually accelerating the return to the past.
I think the ongoing financial crisis is bound to increase these discrepancies, making the analysis/trading/investment/business design of EM a bifurcated exercise. The nature of the analysis is different for a country like Brazil, which has a credible inflation targeting scheme, is a net creditor of G7 and continues to show large FDI, than a country like Argentina. The instruments to trade, the type of trades, and therefore the ensuing liquidity of markets are and will be increasingly different.
Thus, will there be an EM asset class 5-10 years down the road? For now the investor base is fairly unified and there are institutional reasons why it will remain like that for some time. But global macro investors are more and more involved into the former group, making the latter group of countries a niche. Moreover, local markets real money funds are more and more devoted almost only to the converging group. Those funds are most likely the key area of growth on the buy side, which will mark this bifurcation.
Originally published at Non-Trivial Macro Ideas weblog and reproduced here with the author’s permission.