May 2018 – Monthly Commentary
The bastion of calm that swept over capital markets evaporated in May, as a number of emerging market economies and their markets suffered under the strain of bad policy. After years in financial purgatory following their 2001 default, Argentina is again facing financial strain. The serial defaulter returned to the global bond market two years ago with a $16 billion multi-tranche deal that received $70 billion in orders. Investor demand had grown so strong that last year the Republic issued $2.75 billion 100-year bonds in another wildly oversubscribed new issue. With interest rates at artificially low rates in the United States and a voracious appetite for risk, investors ignored the history of the borrower. The euphoria wasn’t limited to the bond market. The Argentine stock market has been on an upward trajectory similar to that of developed market stocks. Foreign money flooded into the country in anticipation that the party would continue indefinitely. Of course, it rarely does when imprudent policy rules the day, as has been the case in Argentina. The Republic has followed a policy of borrow and spend (not dramatically different from the U.S. policy) for years and with their reentry into the capital markets, the profligacy has accelerated. That was until it dawned on investors that Argentina is again over her skis. With inflation solidly in double digits and the debt piling up, investors are on the verge of panic and have begun to sell equities, the Peso, as well as local and dollar-denominated bonds. The repatriation of assets has caused a rout in the peso. As the value of the peso falls, the servicing cost of the debt rises, which effectively increases their dollar denominated debt exposure. In an effort to combat the currency weakness the government raised overnight interest rates to 40% and bought Pesos in the open market. The action seems to be stabilizing the situation for the time being, with each greenback fetching 25 pesos, a 20% plunge in the last month.
Turkey and Brazil are facing similar situations as deficit spending, rising debt and double digit inflation panicked investors and, similar to Argentina, the value of those currencies have fallen by more than 20% versus the U.S. dollars. The irony is that the panic in emerging markets can be directly tied back to the ultra-loose monetary policy of the U.S., European and Japanese Central Banks. In their thirst for yield, investors in the developed markets were willing to invest in risky emerging markets to capture a higher return. When they realized they weren’t being compensated for that risk, they sold and threw the EM economies into disarray. The problem the emerging markets face is that in order to keep their currencies from plunging, they need to intervene and buy their currency and hope that their buying is enough to push the value of it back up. So far, intervention alone has not been enough and all three have been forced to raise short term interest rates in an effort to squeeze short sellers. The problem with implementing an onerous interest rate is that it risks running the local economy into a recession.
At the time of this writing, the International Monetary Fund has announced an agreement to lend Argentina $50 Billion in an effort to stabile their currency. The reaction by the market was to send the Peso to a new low. Despite the emerging market woes, contagion to the developed market seems unlikely, given the momentum of the domestic economies.