Mark Dow: 3 Things Emerging Markets Need For A Rebound

September 08, 2015

Mark Dow is the founder of Dow Global Advisors, based in Laguna Beach, California. He is also the author of the Behavioral Macro blog. Dow has 20 years of experience as a policymaker, investor and trader, focused on global macro and emerging markets. He has been a senior portfolio manager at Pharo Management LLC, a portfolio manager at MFS Investment Management and a senior sovereign analyst at Putnam Investments. Dow began his career in Washington as an economist at the International Monetary Fund and at the U.S. Department of the Treasury. We've seen a big sell-off in emerging markets, with iShares MSCI Emerging Markets (EEM | B-100) falling to a multiyear low.
Mark Dow: Last time we got this low was 2009. It has broken out of that channel it's been in for the past four or five years. What prices do you look for before you would start seeing value in emerging markets? Or is it just too hot to handle?
Dow: I'm not very value-oriented in a certain sense. I started writing in 2011 that I was getting bearish emerging markets and it was going to last a while. It's really the mirror image of what we had seen from 2003 until about 2010. And that just had to unwind. Once that starts unwinding, it feeds on itself, and the asset allocators start needing to get out. You go through the cycle.

Toward the end of that cycle, you see an accelerated phase of risk shedding. And then at some point, you see some combination of three things showing up that will get institutional investors to allocate to the asset class again. For emerging markets, you need these three things to line up pretty nicely.

The first one is U.S. interest rates. You need to have some kind of educated guess as to when rate hikes will stop. We're still at the point where we're kind of guessing when the rate hikes will start. You need to be in a position to feel like you have an educated guess as to where they're going to stop. We're just not there. This is important because the opportunity costs of capital for the people allocated to emerging markets are U.S. rates.

So if rates are going up, it makes it harder to allocate to emerging markets. Emerging markets historically tend to do well when rates are coming down. That's typically the case. It wasn't entirely the case in the last cycle, but it usually is.

Second is the dollar. People are still calling for the dollar to rise powerfully. That may or may not happen. But as long as that's the expectation, investors are going to be wary of allocating to emerging markets because in both local currency fixed income and equities, a significant part of the return is determined by currency, much more than people recognize.

The third factor you have to look for is a projected growth differential. In emerging markets, they don't have property rights. The rule of law is not as strong. So you need to be compensated for those additional risks. And typically that compensation comes in the form of a growth differential—not valuation differential, but usually growth differential. In terms of growth versus the U.S.?
Dow: Yes, versus the developed economies from which the allocations would be coming. And obviously right now that's inverted.
Dow: Exactly. The U.S. is growing better than the emerging markets. It's part of this global deleveraging process. We had a massive wave of global financialization and everybody increased their domestic credit in different ways. The U.S. addressed those issues in a much more upfront way. We had TARP and a lot of people weren't happy.

But in retrospect, it's pretty clear that our aggressive attacking of those problems led us to come out of the deleveraging cycle earlier than others. Europe is going through that in its own way. And emerging markets are chewing through their credit overhang as well.

So we can't quite get to the growth differential necessary for people to feel that allocating to emerging markets is a compelling thing.

You need to predict a path and level of U.S. interest rates, stop forecasting a further rise in the dollar and a growth differential. We're not there now.

However, my posture in emerging markets is—and commodities in general, with the exception of precious metals—that we're past the time where it's easy and safe to short. It's not a good short. It can snap back in your face at any time if these signs start to materialize.

It could well be after the first rate hike that we feel confident—rightly or wrongly—about a path and a level for Fed funds. So it could end very quickly. It's no longer something you want to short aggressively. It's too dangerous, and probably the same thing with commodities. Stand back and wait until these things materialize. You mentioned commodities; let's talk about oil. We saw it spike nearly 30 percent in three days, then fall back, but it appears sentiment started to change.
Dow: Oil is the most highly financialized commodity on the planet. And I don't know what the exact numbers are, but about 80 percent of it is traded by financial operators and 20 percent of it is traded by commercial operators who are hedging or unhedging. It used to be, back in the day, the inverse of that. That makes a difference. So sentiment drives this thing dramatically.

We are seeing a combination of supply and speculation. That's where it started, and then it kind of fed on itself as it went down. Obviously oil prices were extremely high for a long time. In 2008, remember, they got to almost $150 a barrel. That brought a lot of oil firms into production because prices were high. It wasn't, as it's commonly suggested, about low rates. In 2007, when oil was really high, rates were still at 5 percent. They hadn't even started cutting. And we couldn't even spell QE at that point.

The oft-repeated notion that the Fed induced a bubble in oil is wrong. Speculation induced a bubble in oil. It was the speculators that took oil up to $150 a barrel, which led a lot of people to think something fundamental was going on—in this particular case, China and emerging markets increasing demand. That was the story, and they said "We need to produce a lot of oil," and people overbuilt.

Oil companies were lured in by these high prices for a long period of time. And the consequence today for the price of oil was that now these guys are running their businesses for cash, and they can't afford to cut back on their production because they need to meet debt payments and things like that.

These are the dynamics that we're running through right now. Moves like we saw over the past few days are just overwhelmingly about speculation. Oil will eventually find its bottom, and production will be pared back. But these cycles are really long. Tell me about the correlation here—we talked about it before—between emerging markets and oil. Which is the horse and which is the cart?
Dow: That's a great question, a great subject, because I think it's one of the most fundamentally misunderstood issues out there. We've seen emerging markets fall with oil; seems pretty simple.
Dow: It's not; just because two things happen at the same time doesn't mean there's a fundamental correlation.

So you say, why is it then that they trade together? One is this mental legacy that we have, and the other is where these things reside on the risk spectrum. Emerging markets and commodities are the last asset classes that you get into when you're moving out the risk spectrum.

Usually when you're coming out of a crisis, you sell off and investors start buying high-grade bonds or maybe some high-yield bonds or maybe some blue ship equities with dividends. In other words, they start moving out the spectrum.

Historically, the last asset classes you go into when you're reaching for risk are emerging markets and commodities, both of which tend to benefit from low interest rates in the U.S. So that's why we have this link. But fundamentally, it's not well supported.

I'll give you a very clear case in point. Everyone thinks the Brazilian boom over the past eight years has been about Brazil selling iron ore to China. It's a commodity play on China—that's what people have said over and over again; that was the investment thesis.

It's wrong. Why? Brazil's exports are 10 percent of GDP. I don't care how many secondary servicers benefit from the relationship. If it's 10 percent of GDP, it's 10 percent of GDP. It's not a driver. Yes, it was a source of a lot of positive sentiment that attracted a lot of capital flows into the Bovespa. But the real growth story in Brazil was about domestic credit. They had for perhaps the first time, good macroeconomic stabilization, relatively low interest rates, relatively stable inflation. That allowed them to develop domestic finances; this is the global financialization I'm talking about.

They imported a lot of the credit techniques that we use in the U.S. and applied them to Brazil. So all of a sudden, the Brasileiros could borrow to buy a car. They could borrow to buy goods. They could borrow to buy a home. That wasn't possible before. That's what drove the boom.

And of course, when you build up credit really, really fast, at some point, it stops and you have to digest it. That's where Brazil is now. And it's not dealing with it particularly well.

This perception bias—together with an historical legacy by which we think of developing economies as primary resources exporters (despite the fact that countries like China, Korea, Turkey, and Taiwan make up more than 50 percent of EEM)— leads us to overstate the strength of the fundamental link between commodities and emerging markets.

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