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Greed and glory in emerging markets equities

global-investingedited|By Matein Khalid| Emerging markets were an entirely predictable horror story once again in 2015. The oil/mining bust, currency meltdowns, China’s hard landing, sovereign credit downgrades, banking system crises, corruption scandals and geopolitical crises from Ukraine to Syria, the Black Sea to the South China Sea devastated investor wealth in emerging markets.


India’s Sensex and Nifty were down 9% while the rupee has depreciated to 66 against the US dollar. The GCC equities indices and even Egypt, in the epicenter of a $500 billion lost petrocurrency revenue deflation shock due to oil the crash, lost 30 – 35% for investors. Turkey and Brazil, mired in political scandals, inflation crises and banking time bombs, lost 40 – 45% for investors. As the Fed raises its overnight borrowing rate, China devalues its yuan with its new foreign exchange regime, IMF slashes global growth forecasts to only 3%, South Korean, Chinese and Taiwan exports sag as world trade shrinks, it is impossible for me to be a cheerleader for emerging markets. However, amid the carnage, money making opportunities exist from Shanghai to Dubai, from Mumbai or Uruguay.
My best macro call for 2016 is Argentina. President Mauricio Macri, a pro-business reformer, has ended 12 years of Peronist misrule. Macri has fired the central bank governor, ended capital controls, devalued the peso, cut farm export taxes, revamped the dodgy statistics agency (Chinese comrades could use help here!) and negotiated with sovereign debt restructuring holdouts that have prevented Argentina’s return to the international capital markets. Banco Galicia and Banco Macro shares rose 50% in November when Wall Street realized that Macri could move into the Casa Rosada. So don’t cry for me, Argentina. Evita is your tragic past but Macri and Alejandro Allende are your future. Your banking system is miniscule, smaller than Panama. This will change and I must thank the lords of the pampas for the stellar sovereign spreads in Gauchito Bonds sometime this spring.
I would still short currencies with high external deficits, mediocre GDP growth, lousy political governance, high inflation and commodities exposure. This means the South African Rand (though Pravin is back), Brazil Real, Turkish Lira, Indonesian Rupiah and the Colombian Peso. Corporate/banking debt crises will emerge in India and the GCC. African equities will also remain a nightmare and I remain bearish Southeast Asia, notably Thailand and Malaysia. Millennia after the Greeks trapped Xerxes’s fleet in the ancient world’s most epic sea battle before Actium, Greece has been relegated to the emerging markets. My only interest in my beloved Aegean is to take my teenage twins to Mykonos, the scene of my happiest youthful summers.
Emerging markets are 40% of global growth and could well trigger history’s first “Made in China” recession. Brazil’s economy, bigger than Canada, is the largest in Latin America and the seventh largest in the world. Now that Joaquim Levy has resigned, another sovereign debt credit downgrade is inevitable. As a Carioca friend pointed out, Dilma’s approval rating is below Brazil’s 8% inflation rate. Ain’t no sunshine when she’s gone on Ipanema Beach? Not so. Dilma has ruined Brazil’s economy and could well resign, the only reason I would buy the Bovespa, down 43% in 2015.
Now that Russians cannot sunbathe in Bodrum, Marmaris or Kusadasi, the odds of the third Russian Revolution since October 1917 are rising though Alexei Navalny is thankfully no Lenin. No interest in Moscow equities or Russian Eurobonds for now though the rouble has value at 72.
I expect inflation to surge across emerging markets as currencies plunge. The Azerbaijan manat plunged 30% last week after the Baku central bank abandoned its dollar peg. Yet devalued currencies can also boost exports, squeeze imports and compress external deficits. This could be a source of hope in Jakarta and even Istanbul in 2016. US economic data momentum is a big risk if it causes aggressive Federal Reserve tightening and a spike in the US Treasury note yield. China’s hard landing is ugly but could well turn uglier as its trillion dollar shadow (Ponzi) banking system implodes. A consumer debt/mortgage bubble could well devastate Hong Kong, Singapore, Thailand and South Korea. A major sovereign debt default or banking failure could shock Wall Street, given $3.8 trillion in unhedged EM corporate debt. Turkish, Indian, Indonesian, Russian and Mexican corporates and their “kitty banks” are obvious black swans (a philosophical oxymoron?). I am no Cassandra but I babysit multi-generation family money and know exactly what I want. I want inflation linked dividends, no phony accounting, no political risk. I want megacap America and Europe.
Macro Ideas – Sri Lanka’s sovereign dollar bond new issue offers value!
Ceylon/Serendib is a teardrop shaped island in the Indian Ocean that has enthralled me ever since I visited the hill resorts of Nuwara Eliya and the exquisite ruins of Anuradhapura as a boy. The tragic, terrible civil war against the Tamil Tigers (1983 – 2009), the Asian tsunami (2004) and the ten year autocratic “family business” rule of ex President Mahinda Rajapaksa were a nightmare for Sri Lanka. Yet Sri Lanka’s political transformation has not been rewarded by the financial markets.
In January 2015, President Sirisena has replaced the pro-China Rajapaksa clan and marginalized them with a victory in the August 2015 parliamentary election. Sri Lanka finally has a government committed to democratic principles, privatization and economic reform (Colombo as the Indian Ocean’s new Dubai and Singapore? Why not?) reconciliation with the Tamil ethnic minority after the human rights trauma in Jaffna when the military vanquished the LTTE in 2009 and killed Velupillai Prabhakaran.
Sri Lanka’s economy, reliant on tourism, tea exports, a construction boom, services and remittance from its diaspora in the Middle East, delivered annual 6.5% growth between 2002 and 2015, despite the civil war, tsunami, foreign debt crises, terror attacks and political vendettas among the elite. GDP growth in 2015 will not meet the Finance Ministry’s 7.5% target due to a shrinkage in world trade. Sri Lanka could well deliver 6.5% growth. The new government has also slowed Rajapaksa’s Beijing financed infrastructure and vanity white elephant projects as it launches probes into the endemic corruption of his decade in power. While the rupee has sagged 7% against King Dollar and the oil crash will hit Gulf remittance flows, growth will be boosted by a fall in interest rates, export competitiveness and robust consumer spending. President Sirisena’s South African style Truth and Reconciliation Committee can help heal the wounds of the past and attract Washington/London since the UN has applauded the initiative. Sri Lanka also plans constitutional reforms to reduce the power of the executive and empower the legislature so that the arbitrary, corrupt political culture of the Rajapaksa era never again reappears.
This $80 billion economy will be the next Asian frontier Tiger since I believe the Indian Ocean will replace the North Atlantic and the Med as the focal point of Great Power rivalries in the next decade. Prime Minister Ranil Wickramasinghe’s state visit to Japan has elicited the promise of concessional loans and Sri Lanka, which has never defaulted on its external debt even during the civil war, has established an impeccable reputation as a sovereign issuer in the Eurobond markets since the victory over the LTTE in 2009.
Sri Lanka issued a $1.5 billion ten year sovereign bond that paid a rich 6.875% US dollar coupon in October. This bond was widely allocated to US/Europe based emerging markets funds since only 7% of the new issue was given to pension funds, insurance companies and private banks. Yet emerging debt funds were desperate to sell bonds en masse as investors redeemed out of the high yield debt asset class after the Chinese yuan, Third Avenue and Lucidus Capital shocks. So the Sri Lanka new issue bonds have fallen to 93.50 to yield a stellar 8.3% and enable leveraged investors to lock in a 15% annual US dollar return. I do not want to gloss over Sri Lanka’s financial risk metrics. Standard & Poors rates Sri Lanka as only a B+ credit, while Moodys is B1. Foreign exchange reserves fell from a peak of $9 billion in 2014 to below $7 billion, forcing the central bank of Sri Lanka to negotiate a $1 billion currency swap line with the Reserve Bank of India. There is no way the government will meet the Finance Minister’s target of a 4.4% budget deficit and debt/GDP ratios are still too high at 72%. Yet like Benigno Aquino’s Philippines, I believe Sri Lanka is on the path to at least two sovereign credit upgrades if it can implement its reform agenda now that it dominates Parliament. Sri Lanka, like Northern Ireland and Bosnia in the late 1990’s, is a beacon of hope for all of us who are disgusted by ethnic/sectarian hate in the global human family.
Despite the 2010-11 market bubbles, Sri Lanka’s “peace dividend” is not yet reflected in its international bond. The terror threats in the Sinai and Bodrum/Antalya will benefit Russian tourist arrivals. Bank loan growth will boost valuations. The Colombo Port project can well attract $10 billion in FDI, as can Jaffna’s reconstruction. My dream? Sri Lanka as an investment grade credit one day!
Currencies – The bearish case for the Indian rupee in 2016
In spring 2011, an Indian celebrity financier visited the NRI Jay Gatsbys in Emirates Hills pitching his firm’s latest private equity fund. I declined to invest because RBI Governor Subbarao was doing Congress’s bidding with a 20% rise in the money supply. I wrote successive articles in the KT predicting a major depreciation in the Indian rupee and warning my friends to beware the India Shining hype and rupee risk. At an investment conference in London, an Indian bank CEO told me I was clueless about the rupee since I was from the other side of the Radcliffe Award, that the rupee was headed to 35 against the dollar. As always, time will tell, I responded. Fast forward to August 2013. The Indian rupee fell to 68 and the captains and kings (Amils/Bhaibans!) of Emirates Hills lost 50% of their capital due to rupee depreciation alone.
So I watch the fall of the Indian rupee to two year lows at 66 with deep concern. The Fed rate hikes coincide with offshore money outflows from Dalal Street, the reason the Sensex was slammed to 25000. Conventional wisdom states that RBI Governor Rajan, India’s Paul Volcker, alone is sufficient to stabilize the rupee. Wrong. The Indian rupee can well fall to 74 against the US dollar in 2016. Why?
India’s banking crisis is slowly morphing into an external debt crisis. This was the reason the rupee was Asia’s worst performing currency in November 2015, even though crude oil collapsed 12% even before the Vienna debacle. True, RBI reserves are $350 billion, well above the August 2013 “taper tantrum” levels at $275 billion. Yet these reserves are a mere 16% of GDP, far below, say, Singapore’s 100% or Taiwan’s 84% of GDP. India’s foreign debt and external liabilities have risen alarmingly even as the current account deficit has narrowed to 2% of GDP, thanks to a $60 billion crude oil import bill windfall. Note the almost $100 billion in short term hot money, offshore borrowings and NRI deposits via Dr. Rajan’s concessional swaps during the rupee crisis of August 2013. India’s net international investments (assets liabilities) is now an alarming $370 billion, a six fold rise since the 2008 financial crisis. Offshore hot money, short term borrowings and trade credit done is $300 billion.
India’s foreign reserves are low compared to its external debt, a kiss of death for the rupee in a higher Fed rate and King Dollar milieu. India’s external debt (government and private) is now a dangerous 1.45 times state reserves Short term external debt is 25% of sovereign reserves. The real sword of Damocles for the Indian rupee is the surge in private sector external borrowings, now a staggering 19% of GDP. This is primarily due to a binge in Corporate (oligarch?) India’s external commercial borrowings, bank loans, notes and bond issues floated in Vilayetistan. These tripled in Congress’s second term and are 8% of GDP, a sad indictment of Dr. Manmohan Singh’s economics legacy. It is obvious that New Dehli allowed Congress’s darling oligarchs to run amok in the world’s debt private placement and syndicated loans markets.
India’s private sector is leveraged and faces a short US dollar funding mismatch that will spell disaster in 2016 as King Dollar continues to rise. Indian banking’s non-performing/restructured loan ratio is a shocking 11% of all loans in 2015, the reason Dr. Rajan ordered a hike in provisions. Private sector debt has basically doubled in the past decade. To borrow a Churchillian metaphor, never in the history of Indian capitalism have so few owed so much to so many. Corporate leverage is at dangerous levels at a time when world trade is shrinking, $200 billion in bad loans gut the banking system and a fall in inflation has raised real borrowing costs. This is the worst possible global economic and monetary environment to have an external debt crisis. The IMF has warned India about its high foreign exchange leverage. The IMF estimates that 60% of Indian corporate debt is at risk given the US dollar/Fed rate shock. While the RBI will manage the rupee’s fall, it will not prevent it, if only because the currency wars have now come to Mumbai, thanks to the Chinese Politburo. The offshore debt chickens of India Inc. will come home to roost in 2016.