Mark Dow’s Emerging Market Play

April 11, 2016

Emerging markets have been bouncing from multiyear lows in recent weeks. But there’s a lot to consider before buying into the notion that we have seen a bona fide bottom, according to Mark Dow. Dow is the founder of Dow Global Advisors, based in Laguna Beach, California. He is also the author of the Behavioral Macro blog and a frequent commentator in the financial media.

Dow has 20 years’ experience as a policymaker, investor and trader, focused on global macro and emerging markets. He began his career in Washington as an economist at the International Monetary Fund and at the U.S. Department of the Treasury.

ETF.com: I recently read a commentary that said key central banks around the world—U.S., Japan, the eurozone and China—are seeking a currency truce. None of them wants to see the Chinese yuan devalue any more, or policies that pursue a stronger dollar. Do you agree with that?

Mark Dow: I don't. We tend to over-predict coordinated actions. Yes, central banks do talk to each other, but the bar for high levels of coordination is just way up there to actually see them change their domestic policies in the benefit of someone else.

If you look at what Japan did and what Europe did, both of them have been more accommodative after the Shanghai G-20 meeting than people anticipated. But the currencies went up. Personally, I was looking for the euro and the yen and emerging markets currencies to rally, just because sentiment and positioning had gotten so extreme. So, for me, it wasn't a surprise, and I was less inclined to think it was some kind of conspiracy theory.

The people who seem to be most strongly advocating a high degree of coordination among central banks are the same people who are most bullish on the dollar and who are probably most wrongfooted. The market was primed for a countermove in the dollar because people were so negative, and positioning was so one-sided.

Take the euro, for example. If you look at the charts, it was back in December when the euro came off its bottom. It had a big move up, and then it didn't retrace that move the way it had been in the downtrend, it went sideways for a while. From a behavioral standpoint, that usually tells you there are very few people left to sell. People are already maxed short.

I know anecdotally, from the messages I get from other hedge fund managers, they were all long dollars and asking me, "What do you think?" When guys like that ask you what you think, it's usually because they're uncertain about their own views. That's what I've seen over the past few weeks. Put all of those things together, and I think the story is dramatically overblown.

It's true that people were concerned about the dollar, but the dollar's been going sideways for maybe a year now except against the emerging currencies, and those have been bombed out.

ETF.com: What’s your view on emerging markets right now?

Dow: That it's too late to short emerging markets. And it might be too early to buy, but it's just too late to short.

And if you want to get involved, get involved in local-currency sovereign bonds. Because you get good yield and you're not taking credit risk, because there's not good growth in emerging markets, and the currencies are pretty thoroughly bombed out.

ETF.com: What’s been driving this recent resurgence in emerging market currencies?

Dow: It really started in January. When we had that second dip in the S&P 500 in February, emerging market currencies did not sell off nearly as aggressively as the S&P 500 did. That was a sign technically that emerging market currencies were stretched in the negative direction.

ETF.com: This has been, then, a technical move? And has anything fundamentally changed in emerging markets?

Dow: The way these processes tend to work is that first you have an extreme sentiment and positioning reading. And you have a bounce. And then at some point, among the people who are playing the bounce, sentiment starts to change and some get outright optimistic. At some point in that process, we can see signs that the fundamentals are improving in a way that validates that move.

But that move can be quite violent, because so many people say, ‘OK, this is it, this is the big chance. We need to get in emerging markets. We know this is a multiyear trade when it turns. And we don't want to be left behind.’

But often these things turn out to be a false move. And then you retrace. And then people go back to the negativity they had before, but not as bad as the previous time.

You have these oscillations of relative pessimism and optimism until such point that the fundamentals start to change. That's what the bottoming process looks like—a series of false rallies until one of those upward moves gets validated by fundamentals.

That's where we are today. We're beginning a bottoming process in emerging markets in general, and the currencies in particular. It's going to go up and down from here. But it's going to do that until the emerging market fundamentals start to get better.

ETF.com: And what needs to happen in the emerging markets for fundamentals to improve?

Dow: Primarily, three things need to fall into place before you get bullish about emerging markets.

First, we have to have some sense about where the U.S. is going with rates. We're starting to get that sense. We've had our first hike, and we know it's going to be very gradual, and probably very modest.

The Fed and everyone else keeps ratcheting down their future growth rates for the U.S., and we're realizing that we're not going back to the levels of growth that we enjoyed before the financial crisis. There're some structural factors that constitute head winds. So the rates are low, and they’re also low in all the other developed economies.

But we feel better about rates. It's safer to be long rates and it's safer to be long emerging markets. Before, we were worried about a rapid rise in rates, and historically, that does bad things to emerging markets.

The second thing is we need to know where the dollar ends up. The dollar's rise has to end, or we have to be confident it's not going to get really strong from here. We've seen a lot of that already.

People realize we've seen the radical move in the dollar, and from now on, even if the dollar were to go back up again, it's probably not going to go up with the same kind of violence it did over the past 18 months. And if it did, it wouldn't surprise as many people as it did back then.

The final thing we need in emerging markets is growth. People need to see a growth-differential to feel better about emerging markets. We know the case of Brazil, for example. People think the Brazilian boom was based on commodities. But anybody who looks at the numbers knows that before the big boom in Brazil, exports were 16% of GDP. A few years ago, exports were only 11% or 12% of GDP. Brazil wasn't driven by an export boom. We know what it was driven by.

ETF.com: The democratization of credit?

Dow: Exactly. Everyone for the first time could go out and buy on credit, as much as they want. And this happened not only in Brazil, but in almost all of the emerging market countries.

The developed economies, all the banks in Europe and the U.S., they exported the financial techniques they’d been using at home. They said the first one to get to Brazil, to South Africa, to Turkey, to Korea, these are the guys who are going to make the money. And they arrived. And that pumped up the economy.

Because these economies started from a lower level of domestic debt, household debt, it's not as tragic. But it's going to slow down growth until they start paying off this debt and grow their way slowly out of it.

In the meantime, there's no growth, and it makes countries vulnerable to policy mistakes. We've seen some of that with Dilma [Rousseff] in Brazil, and we've seen that a little bit in Turkey. Ultimately, there are a lot of reasons to believe this isn't going to be an old-fashioned emerging market crisis. We have flexible exchange rates. We have more reserves. We have deeper financial institutions, domestically. So financial markets there are a lot deeper.

For now, basically, the growth component is not there, but the financial landscape is such that they'll probably muddle through and, over time, growth will start to emerge.

ETF.com: Once these three factors are in place, U.S. investors should capture the upside through stocks, local bonds, currencies, all of the above?

Dow: I'm not excited about emerging market equities yet because of the lack of growth. But it’s time to get fairly aggressively long emerging market local sovereign debt.

If you're playing this at home and you believe we're at the beginning of a bottoming process, you don't want to buy equities now. You have to reconcile yourself to the notion that you might miss the bottom, but you really can't add here because we're probably going to be going up and down for a while.

There's no growth to turn the earnings around. The currency will make people feel better about stocks. And we've seen the rally in emerging markets such as the Bovespa [Brazilian stock market]. But there's probably no earnings power underneath that.

My guess is that this rally will fade a little bit, and we're going to have another swing toward pessimism at some point. It won’t be as deep as what we had in January. But we'll find better prices to buy things. And if you already have a position, hang on to it.

On the other hand, the great thing about local currency sovereign bonds is that they have a really nice yield. And if you think the currency has taken its biggest hit, it's going to be hard for the currency to depreciate more than the yield you're getting from those bonds. You could build a diversified basket of emerging market local currency sovereign bonds. That's the best vehicle at this point to play emerging markets.

But the time for being bearish is over. The backdrop is that we have a rolling global deleveraging process. The U.S. is ahead of everybody else. And now everybody else is catching up, emerging markets included. They're going to have to work their way out from under their domestic debt burdens.

ETF.com: How linked is what’s going on in commodities markets to emerging markets? We often hear they go hand in hand.

Dow: It’s interesting that we’ve also had a bear market in commodities. But the link between the two is much more sentimental than fundamental, because the big countries like China, Turkey, India are commodity importers. The world I grew up in where emerging market economies were all commodity exporters doesn't exist anymore.

If you look at the iShares MSCI Emerging Markets (EEM | B-100), the top country exposures and about 55% of the portfolio are commodity importers.

But commodities and emerging markets are linked psychologically for a lot of people. And they're on the same end of the risk spectrums. They're both considered high-risk investments, so people don't go into them until they're really ready to take risk. There’s a correlation, but the causation isn't fundamentally sound.

The point I would make is that if you look at what's happening in commodities and emerging markets right now, those two are trying to find a bottom. And they do correlate, even though there's no fundamental linkage between the two.

Contact Cinthia Murphy at [email protected].

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