Earlier we presented a very bearish piece on Emerging Markets from UBS. Now we highlight a somewhat opposite view from Hermitage Capital Management, which does not share quite the bearish sentiment on EM's but rather is very bullish on "frontier" markets: Kazakhstan, Saudi Arabia, Abu Dhabi, Lebanon and Nigeria. One interesting observation from Hermitage when asked which currency to own: "The answer is none of the developed market currencies...If the supply of fiat currencies is changeable at the whim of government policy, while the supply of gold or oil is fixed by the physical limitations on new production, which would you rather own as a store of value? The answer seems pretty clear to us. You want to own the commodities because they are insulated from the actions of vote-seeking politicians and their amenable central bankers who in our view will carry on in debasing their currencies." Can we get a Gold, B#@$&*s?
On the other hand Hermitage was down 42% in 2008 and up 16.31% in 2009 so tread carefully.
Our normal practice as we enter a new year is to share our predictions of the big market events and trends we see materializing in the coming year. Last year at this time, we predicted a number of breakdowns in the world financial system, many of which occurred in the first quarter of 2009, but later reversed. Once the scope of the economic catastrophe the world faced became clear, governments responded with an unprecedented intervention that kept financial markets and economies from imploding and fueled the rally we saw unfold over the rest of the year.
We began last year by pointing out that commercial banks were so insolvent that we thought they would be forced to “gate” deposits to stay afloat. For the first three months of the year, it looked like we were right. Western banks were in such trouble that they lost 52% of their value by March (S&P 500 Financials Index). By that point, nobody wanted to keep their money in any commercial bank. The one thing we did not anticipate was the speed and size of various government responses to this. Ultimately, multi-trillion dollar support programs resulted in a spectacular recovery that drove bank stocks to finish the year up 15%.
We also predicted a collapse in long-term government bond prices as governments flooded the market with new bonds to finance these bailouts and other economic stimulus packages. We were correct in the direction of our view, but not in the severity. In 2009, the yield on 30-year US bonds rose from 2.68% to 4.64%. The main reason yields didn’t rise more significantly is that at the same time as governments were flooding markets with new bonds, those same movernments had their central banks purchase the bonds with newly printed money. Had these central banks not been participating in their own bond markets, long-term yields would be much higher (we will come back to this point shortly).
We also predicted a wave of sovereign defaults. This appeared imminent for much of the first quarter last year. Ukraine and Ireland began 2009 with serious debt problems which only got worse. Over the first quarter, Ukraine’s CDS spread (the cost of insuring against a default) rose from 3,296 bps to 5,545 bps (+68%) while Ireland’s rose from 103 bps to 304 bps (+195%). Concerns over the impact of an Irish bailout on the developed world grew, and the average G7 CDS spread nearly doubled (rising 94%) in the first three months of 2009.
Everything changed, however, when the G20 countries met in London in early April and added a total of $750 billion to the IMF’s capital, equipping it to rescue any country on the verge of collapse. With the IMF’s newly fortified “war chest,” investors began to relax about the risk of default and contagion between countries. Ireland’s CDS fell 64% over the rest of 2009, ending the year at the same level it began, while Ukraine’s CDS ended 2009 47% below where it started.Investors, it seems, are no longer panicking about the solvency of countries. This is not likely to last, and again, we will come back to this point in our predictions below.
Finally, we predicted that gold would become a true store of value as investors started to distrust fiat currencies. This prediction has started to work out very well. Gold began 2009 trading at $875 an ounce, and it rose as high as $1,220 in early December before finishing the year at $1,098.
So where does this leave us going forward? The basic answer is that due to the unprecedented role governments assumed in financial markets in 2009, a significant part of our investment outlook is based on the effect these government actions will have on asset prices.
Our predictions for 2010 are as follows:
1. Commodities and hard assets will continue to appreciate in response to the ongoing debasement of fiat currencies.
Government deficits in developed countries have risen very sharply as a result of the massive intervention used to save the world from financial collapse. Since 2007, the US government deficit has risen 11-fold, from $161 billion to $1.84 trillion while the UK deficit has grown more than 16 times: from £8 billion to £132 billion. To finance these deficits, governments have had to significantly increase their debt burdens. In the US, total government debt has risen by 41% since 2007, while in the UK it has risen 54% over the same period. If governments had sold this new debt directly into the market, it would have overwhelmed demand and caused long-term interest rates to spike, thereby destroying any beneficial impact of other policies to avert a global depression. To avoid interest rates rising, central banks have simply printed money to buy many of these new bonds.
Clients often ask us, “Which currency would you own now?” The answer is none of the developed market currencies. Since the credit crisis began, the European Central Bank has expanded its balance sheet by 53%, the Federal Reserve’s has grown by 157% while the Bank of England has nearly tripled its balance sheet, growing by 198%. At the same time, one of the central investment virtues of commodities is that their supply is constrained by natural factors limiting physical production. Gold and oil production have only increased by 1.1% and 1.6%, respectively, since the end of 2007, while copper production has actually fallen 0.7%. Sometimes the simplest logic leads to the best investment decisions. If the supply of fiat currencies is changeable at the whim of government policy, while the supply of gold or oil is fixed by the physical limitations on new production, which would you rather own as a store of value? The answer seems pretty clear to us. You want to own the commodities because they are insulated from the actions of vote-seeking politicians and their amenable central bankers who in our view will carry on in debasing their currencies.
2. The yields on long-term US government bonds will rise significantly.
This is a reiteration of our prediction last year, which was only partially realized. The logic behind it is fairly straightforward: if there is an increase in the supply of bonds while demand stays the same, then the price of bonds will fall and yields will rise.
The US government has had to sell $3.6 trillion in new bonds since 2007 – a 41% increase in total debt. Without a corresponding increase in demand to buy these newly issued bonds, the price would have to fall (and the interest rate will have to go up). While the “flight to quality” in the depths of the crisis spurred demand for treasuries and soaked up some of the new supply, this demand is fading as the world normalizes. At the same time, usually reliable purchasers of US debt appear to be growing increasingly skeptical. The Chinese central bank, which is one of the biggest buyers of US treasuries, has openly challenged the US on its fiscal and monetary policy.
In December, Zhu Min, Deputy Governor of the People’s Bank of China, told an audience, “The world does not have so much money to buy more US treasuries. The United States cannot force foreign governments to increase their holdings of treasuries. … Double the holdings? It is definitely impossible.” This is not the only time the Chinese have expressed this sentiment. Further, we suspect they are just saying out loud what most central bankers are thinking privately.
As we mentioned above, the only reason why bond yields have stayed low is that the Fed has been printing money to buy these new bonds, which is essentially a way for the Fed to manipulate interest rates. This cannot continue forever. At some point the inflation caused by new money being printed to keep yields artificially low will force a “buyers’ strike” on treasuries, which will cause yields to rise.
3. There will be a second wave of sovereign debt problems among both developed and emerging markets countries with weak balance sheets.
In our opinion, the events in Dubai in late 2009 were just a prelude to a series of debt “restructurings” and other sovereign debt problems that we expect to unfold over the course of 2010. While many investors are understandably relieved that the worst of the financial crisis appears to be over, in fact the debt problems of many countries have only gotten worse.
For example, Ireland, which was at the center of market anxiety about a potential default a year ago, has seen its debt burden increase from 44% of GDP at the beginning of 2009 to 65% now. The situation is similar in Spain, where debt has grown from 40% of GDP at the start of last year to 64% now. Ironically, the sense of relief that many investors now feel has allowed many uncreditworthy countries to add on to their already unsustainable debt burdens.
How much debt can a country assume before it is pushed over the edge? It’s not a simple formula and varies from situation to situation. That said, there are levels at which the risk of a default rises significantly: when Brazil defaulted in 1999, it had debt as a percentage of GDP of 50%, Argentina had 55% at the time of its default in 2001 and Russia had 75% when it defaulted in 1998. These numbers are easily exceeded by a number of heavily indebted countries in Europe today. Hungary’s debt is 78% of GDP, Italy’s is 114%, Estonia has 124% and Greece has 125%.
What is always unknowable is the precise moment when a debt burden will become unsustainable. “Unsustainable” debt levels can persist for a long time. Between 1990 and 2001, Argentina comfortably increased its debt by 1.5 times, reaching 55% of GDP without any resistance from the bond markets. Investor willingness to buy Argentine bonds vanished suddenly in December 2001, however, when an unexpected recession materialized and the currency peg broke. The government was forced to default in December 2001 in the face of a devalued peso and insurmountable servicing costs on its foreign debt. Russia had a similar experience with an abrupt change in investor sentiment. It was able to increase its debt burden from 50% to 75% of GDP between 1995 and 1998, and it was only in the immediate aftermath of the Asian crisis that investor risk aversion spiked and the market for short-term Russian debt vanished. The government was unceremoniously forced to default in August 1998.
Looking forward over this year, there is certainly some chance that all these heavily indebted countries in Europe can avoid a default so long as there are no negative catalysts – but we feel that is a rather hopeful worldview. If our previous prediction about a rise in long-term US interest rates is correct, then it could be the negative catalyst that pushes a tenuous country over the edge and into a debt crisis. Similarly, a debt crisis in one part of the world could be the impetus to push another unrelated country into default as the demand for all forms of risky sovereign debt
disappears. The one factor mitigating our concern over this scenario is that even if specific countries go into a debt crisis, we expect governments to be as proactive in avoiding market disruptions as they have been since the Lehman collapse. Should a country run into problems in 2010, we would expect to see strong multinational support to avoid the ugly outcomes we saw in Russia and Argentina several years ago.
4. Frontier markets will catch up to emerging markets.
Frontier markets missed 2009’s emerging market rally. Last year the MSCI Frontier Markets Index underperformed the MSCI Emerging Markets Index by 66%. The underperformance of frontier markets is even more dramatic on a country-by-country basis. While India, Indonesia, Russia and Brazil were up 84%, 117%, 129% and 145%, respectively, in 2009, major frontier markets like Qatar, Kenya, Kuwait and Nigeria returned 1%, -5%, -13% and -38%, respectively (all US dollar returns).
One of the biggest reasons for this disparity was the massive amount of money flowing into exchange-traded funds (ETF’s) last year. Of the total $81 billion that flowed into emerging markets last year, some 54% came into ETF’s, which focus only on the most liquid stocks in the largest markets. As a result, frontier market equities were largely overlooked. While this made sense in an environment like 2009, where investors wanted to buy whatever they could very quickly and easily in order to lock in exposure to the steep relief rally, we expect more attention to be paid in 2010 to those markets that have missed the rally. Moreover, if investors get more comfortable with the durability of the recovery, the illiquidity of many frontier markets will no longer be a big deterrent to investment as it was in 2009. A market like Nigeria, for example – which has 7% GDP growth, $43 billion of central bank reserves, a 2% current account surplus and where oil accounts for 90% of export earnings – stands out as a potential outperformer in 2010.
So how are we positioning the Fund with these predictions in mind? First, because of our positive view on commodities and hard assets, 61% of our portfolio is invested in commodity-related companies or firms with portfolios of hard assets like real estate. Gold makes up a further 7% of the portfolio. Because of our view on frontier markets, 21% of our portfolio is invested in frontier market countries like Kazakhstan, Saudi Arabia, Abu Dhabi, Lebanon and Nigeria.
Due to our expectations of sovereign debt problems, we are generally wary investing in countries with huge debt burdens like Ukraine, Hungary and the Baltics. Valuations would have to be extraordinarily compelling before we would invest in a company exposed to this kind of macroeconomic environment. At the same time, our concerns about increases in long-term interest rates compel us to be underweight financials. Banks comprise 25% of the total market capitalization of emerging markets, but they make up less than 8% of our portfolio.
Our biggest mistake in 2009 was being too cautious for too long. The vast majority of stocks that we did own significantly outperformed the market because most of them were hard asset-focused, deep value stocks – but we owned too little of them. As we start the new year, the Fund is nearly fully invested (87%), and we think our continued focus on low valuations and hard assets will perform well in 2010. As this newsletter goes to press, we are up 5% so far in January as some of our deep value ideas are starting to work out as we expected.
Hermitage Capital Management