The Bhutan Dry Docks - UBS Sales Calls For A Top In Emerging Markets
From UBS Macro Sales
Paul Donovan - our celebrated chief economist - was on top form yesterday. Speaking in front of a large audience at our German Macro Conference he outlined his vision of the future. In a typically barnstorming performance, Paul pointed out the problems of the small business credit cycle, the lack of need to be too concerned about developed world inflation and his belief that the sovereign bond market was going to be one, if not the worst, performing asset classes in 2010. he presented a very convincing case, that interest rates in the developed world would rise during Q2 of this year, not in response to inflationary pressures but rather as a requirement to soak up excess liquidity in the system once bank credit conditions started to improve. He specifically forecast that Us and Euro-zone sovereign bond rates would rise by between 100bp-150bp over the course of the year, to a more "natural" level of 5.00% As ever choosing the right phrase, Paul suggested that 2010 would be just like 1994. I must confess that I only half heard the rest of his talk because, dear reader, I lived through 1994 and as I remember it didn't turn out that well for many of us.
Picture the scene. It is 1994, your humble correspondent has by a bizarre set of circumstances become an emerging market hedge fund manager based in New York (Although for tax reasons my domicile was the Cocos Islands (1)). Those were the days when emerging markets really were emerging. I was involved in Russian voucher privatisation where I employed the KGB in order to help me purchase stock in Gazprom, investigated gold properties in Ghana where we had to hurl hand grenades into artisanal workings in order to kill the snakes and spiders that swarmed inside in the darkness and dealt with such legendary characters as the Chandler brothers and the great Thorpe McKenzie (who once made a fortune out of the ruthenium market without he or I ever knowing what ruthenium was actually used for - we used to mumble something about "various electronic uses, but I don't believe that either of us ever actually knew).
It was a simpler time, a better time in which emerging markets were the hottest sector of the investment universe. The developed world was ex-growth. The new engines of the global economy were in Asia and South America. Hot new emerging market IPOs flew off the shelf, sovereign risk spreads collapsed. We has seen the future and it had moved East. Such was the demand for emerging market paper that w could and would buy and sell anything. Even Bhutan Dry Docks. On April 1 1994, a stockbroker in Hong Kong advised his clients to buy shares in Bhutan Dry Docks and received several large orders for the shares. Unfortunately for those who placed the orders, Bhutan, being landlocked, does not have any dry docks. Nor does it have a stock exchange. (2)
Looking back in hindsight there is no doubt that there was the mother of all bubbles building in emerging markets in 1993/94 - Bhutan Dry Docks was just the most outrageous example - but it is also true that just like in every serious bubble there was at the heart of what had become speculation a good fundamental story. The collapse of the Soviet Union had opened up huge new markets, emerging Asia was starting to grow very rapidly, the end of the Cold War meant that political governance was improving in Africa. All of these factors were valid reasons for believing in emerging markets. The problem was that as confidence in our world view grew, we began to believe too much and natural caution turned into what was later (and in the context of another bubble) referred to as irrational exuberance. We also failed to properly consider that part of the growth "premium of emerging markets was the very subdued trading conditions in the developed world; depressed conditions that had caused the Federal Reserve to embark on a sustained series of interest rates. But as 93 moved in to 94, the US economy gave clear signs of turning and as it did so, the Fed let it be known that the next move in US interest rates would be up and that it would happen shortly. There was complete transparency. We all knew that rates were going to rise, we all knew when they were going to rise and were almost all unconcerned. The emerging world growth story was so strong, so persuasive that a modest recovery in the US would not be enough to discourage investment in the new frontiers. Unfortunately we were wrong.
The chart shown above displays the Fed Fund rates from 1985. Note the rise and fall of rates between 86 and 92 and the long period of unchanged settings before the first increase in 1994. History never repeats itself exactly but the shape of this chart looks rather similar to that of the period 2004 to 2008. even the flat-line period is approximately the same length.
To return to 1994. I vividly remember the date Alan Greenspan raised rates because nothing happened. Nothing happened again the next day and then the next but on the third all hell broke loose as emerging markets began to collapse. Faced with an improving US economy and the prospect of higher rates, investors shifted money out of our world and back home. The Russian market cratered. One day I realised that the few of us left in the market were all forced sellers - there was not a single buyer in the market. It was both frightening and mortifying. There were a few attempts a n EM rally through the summer but they all proved to be dead-cat bounces. Under our very feet the investment paradigm shifted. Now emerging markets were risky and growth abounded in the new technologies of the developed world. Tech offered growth without political risk (which of course was correct but ended in another awful bubble but that's another story). It's an event that has been scarred into by soul. When US rates turn after a long down-turn, then it is almost never good news for liquidity driven bubbles such as the 93/94 EM boom.
To return to the present. Paul Donovan suggest that US rates will turn in Q2 of this year and that the long end of the yield curve should rise by 150bp over time. Paul's timing may be out - I personally don't think so but he is more punchy than most - but it is certain that the next move in US rates is up. It is just a question of when. So the question to consider is whether this turn in policy will serve to burst other liquidity bubbles or whether this time it is different. Over the past six months I have pointed out what I believe are clear signs of an asset bubble in traded commodities fuelled, I have argued by liquidity induced physical and paper investment. At the risk of some repetition, let me show what I feel are the two charts that most vividly point out this phenomenon.
The first chart plots the price of copper (yellow line) against the level of copper stock held on the LME (orange line). Logically if the level of stock increases then copper supply exceeds demand and vice versa. Hence there has been an almost 30 year negative correlation between stock level and price. Except in 2009 when from the middle of the year stock levels have increased at the same time as prices. Whatever is happening in the copper market it is hard to argue that it is driven by supply and demand for physical metal.
The second chart shows the production of raw steel in China (yellow line) plotted against the price of HRC. Note the almost one to one correlation of both charts until recently as Chinese production increased in response to demand, falling when prices collapsed. However this did not happen in 2009. Steel production soared onwards and upwards whilst the steel price actually fell. Once again the chart shows that something remarkable is happening but I struggle to see how it can be called economically rational. I have argued that when the liquidity which has allowed both unusual price events to occur is withdrawn then we will see a day of reckoning. I just have not been sure when.
But now consider a third chart. This was Bloomberg's chart of day on Friday. The on graph comments are supplied by Bloomberg and not me.
The chart shows the sovereign CDS spreads of a number of the peripheral Euro zone countries, plotted alongside those of India, Malaysia, Thailand and Korea. Now I know that the CDS market can give a number of unusual signals, but even so I find this chart remarkable. It states that the default risk of these members of the Euro Zone is 50% greater than that of the Asian emerging market countries. Really - are you really saying that Italy is going to default?
India is next door to an imploding nuclear armed neighbour, food price inflation is 20% and rising and the country had a combined federal and provincial deficit of 8% of GDP in 2009. Thailand has suffered a number of political coups in recent years and almost collapsed during the last Asian crisis - which in case you were forgetting started when the country devalued the Baht in July 1997. South Korea has an even more unstable neighbour to its north which will ultimately collapse - hopefully peacefully but in whatever form, certainly most expensively, whilst Malaysia imposed currency controls during the last crisis. Look I know that things are bad in the Euro zone - I've spoken about it before - and may be very serious indeed for Greece. But Germany and France stand behind the Euro - who knows stands behind the Won (for example). I agree that the CDS of the Euro zone countries should be increasing, but I find it hard to believe that they should trade at such a discount to countries in Asia that I would argue also face their own problems.
To me this is our Bhutan Dry Docks moment. The economic argument supporting EM investment is valid -as I pointed out earlier, you can't create a bubble without something that initially supports investment flows - but its gone too far. When I read market commentary that suggest that the Shanghai composite share index (see below) is now better value because price earnings ratios have come down from 100 to 50 its like déjà vu all over again. I wrote stuff like that back in 94 - just before the peak - just before the crash - just before the US rate cycle turned. I'm calling a top in emerging markets (rather coincidently so did Andy a few hours ago). Q1 2010 will still see massive money flow into the asset class as portfolio decisions are driven by last year's stellar performance and developed market pessimism, but starting in Q2 as Paul's setting change comes closer, it is time to call a top to the twin liquidity bubble of this cycle - traded commodities
and emerging markets.