Capital flight from emerging markets during the past year has totaled nearly $1 trillion. Now that volatility in the capital markets is resurgent, with developing economies at the forefront, investors should be asking themselves where the hidden correlations in their portfolios are buried.
By hidden, I mean a correlation between two or more materially important variables that moves countercyclically to global risk appetite. Historical examples of the deleterious effects of hidden correlations on investors aren’t difficult to find. In the Asian and Tequila crises of the 1990s, for example, widespread currency mismatches between assets and liabilities created hidden correlations between exchange rates and credit risk. These hidden correlations burned investors when default and devaluation risks materialized at the same time.
For emerging markets today, likely causes of near-term volatility include a combination of uncertainty over Federal Reserve policy, China growth troubles and the recent commodity bust.
The core underlying causes behind recent emerging-markets losses should be probed to identify mechanisms through which recovery or protracted underperformance might unfold. This search points us toward three important issues to watch during the next 12 months: the foreign exchange–commodity nexus, emerging-markets systemic risk and Brazil.
During the past year, expectations surrounding the unwinding of quantitative easing and a future rate rise by the Fed have resulted in the U.S. dollar’s significant strength against other currencies. The Fed trade-weighted dollar index, which stood at 102 in July 2014, has increased sharply to about 120 at present — a level not seen since April 2003. The fact that international commodity prices are quoted in dollars mechanically links their fall to the strength of the U.S. dollar: a hidden correlation. Thus, whereas excess supply has driven the fall in oil prices, and lower Chinese demand has driven the collapse of iron ore, gold and coal prices, the U.S. dollar appreciation explains much of the breadth of the slump in global commodity prices.
A broad-based drop in commodity prices, in turn, triggered the emerging-markets fallout by severely reducing foreign exchange inflows across commodity exporters. An overlooked culprit explaining the size of the joint forex and growth responses in several of these economies is the significant foreign direct investment–financed increase in commodity production capacity that took place from 2010 to 2013, when commodity prices were booming. The subsequent investment activity increased current- and capital-account exposures to common commodity price risk factors. During the commodity bust, simultaneous falls in exports and foreign direct investment have weighed disproportionately on the currencies of Colombia, Peru, Chile, Mexico and Brazil.
A rapid recovery in commodity prices, which a weaker dollar would facilitate, would throw this process into reverse. In the more likely event that commodity prices are slow to recover, the key question becomes how systemic risk — a known amplifier of existing macroeconomic weakness — would evolve.
Systemic risk levels in emerging markets are at ten-year lows. Although current sovereign exposure to exchange rate risk is muted compared with levels seen during the latter half of the 1990s, nonfinancial corporate leverage and exchange rate exposure have increased significantly in several emerging markets and represent additional sources of vulnerability. Since many emerging-markets sovereigns are better prepared than they were in the 1990s to weather external shocks, it behooves opportunistic investors to look for exceptions to these trends. Such a search leads us to Brazil.
The Brazilian financial sector stands out as a credit and systemic risk hot spot in Latin America. At the same time, Brazilian sovereign spreads have widened significantly since the oil bust began in mid-2014, diverging from other sovereign spreads in the region, whereas spreads on domestic Brazilian government debt are at highs not seen since the 2008–’09 financial crisis.
Although much of the focus has been on Brazil’s political drama, a hidden correlation menacing investors in Brazil today lies in the interaction between sovereign and financial sector credit risk. When a risky sovereign seeks credit from the risky banking sector whose deposits it guarantees, there can be nasty feedback effects. Just ask Greece and Venezuela.
On a more contrarian note regarding Brazil, it’s worth remembering that the current hubbub actually has a prequel. Thirteen years ago, Brazil snatched victory from the jaws of capital market defeat as oil prices begin a spectacular ascent. Investors who went long on Brazilian forex and debt in 2003 were rewarded handsomely in the years that followed. Fans of the prequel may find hidden correlations — and systemic risk — to be effective foreshadowing devices in this present emerging-markets spectacle.
Samuel Malone is director of the specialized modeling group at Moody’s Analytics in West Chester, Pennsylvania.
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