While stock benchmarks around the world, such as S&P, Eurostoxx, FTSE and Shanghai Composite, were generally down -3% in January – and the previously high-flying Nikkei down -8% – the real news may be found across the yield curve.
In his monthly investment letter reviewed by ValueWalk, John Brynjolfsson, who runs approximately $1 billion for his hedge fund firm Armored Wolf, notes with alarm emerging market bonds were down -10% and emerging market equities were generally down -8%. Led by concerns in Argentina, the run for the exits out of emerging markets led to a flight to quality as US Treasuries, UK Gilt and German Bunds, which rallied approximately 2.5% on the emerging market exodus.
“As US dollars flooded the global market, emerging market sovereign countries were able to finance twin fiscal and current account deficits,” the letter notes. “As the US Federal Reserve announced a tapering of its purchase program, those emerging market sovereign countries with twin deficits could no longer rely on external funding to balance their accounts. As global investors withdrew support, Treasury officials in those sovereigns saw international reserves being drained to support currencies that were suddenly vulnerable to depreciation.”
In addition to emerging market flight, Brynjolfsson notes the market “wobbles” are likely caused by Fed tapering, reducing the historic purchase of US government debt, and also what the fund manager calls the “Impossible Trinity,” which is the notion that “no country (or currency block) can simultaneously have a fixed exchange rate, free capital flows and sovereignty over monetary policy.”
Impossible Trinity as seen in China
Considering his theory as it relates to a critical cog in the global economic growth puzzle, Brynjolfsson applies the Impossible Trinity thesis to China, where he pays close attention to the exchange rate, capital flow and monetary policy arenas. These areas had in the past been centrally managed by the Chinese government. In trade deals, Chinese manufacturers would sell products for US dollars and exchange them at a fixed rate for the Chinese currency to pay employees. To manage their currency flows, the Chinese would typically invest the US dollars it received in US Treasury Bonds or other forms of US debt, pegging their currency to the US dollar.
In 2005 this system changed when the Chinese currency was allowed to appreciate in a semi-autonomous market. And this it did, moving higher by 36.5% and bringing with it inflation and higher costs for Chinese – all the while Americans enjoyed endless cheap Chinese imports with relatively low inflation.
In recent years, the rate at which China accumulates US debt has slowed considerably as the Asian nation has made internationalization of its currency a priority, relaxing their exchange rates and capital flows. International participants can trade the Chinese currency and invest in debt instruments while capital flow restrictions are slowly relaxing. Tracking Chinese purchases and sales of US debt is important, but so too is keeping an eye on emerging markets.
Emerging market trends
Brynjolfsson keeps one of his many focuses on emerging markets. “Emerging markets, now greater than half the global economy, saw $4 trillion of foreign fund inflows after the Lehman crisis and the IMF says $470 billion is directly linked to money printing by the Fed,” the letter noted. “If emerging market central bankers are forced to hike rates to defend currencies and reserves, the deflationary impacts would compound the already strong deflation throughout much of the Eurozone. Japan has suffered decades of deflation, corporate profits stagnated, investment atrophied, innovation fizzled, and high real interest rates compounded the debt burden on a base of shrinking nominal GDP.”
Finally the former PIMCO fund manager notes with concern the recent puzzle China finds itself in and how it must delicately manage complex decisions that are mirrored in Western Economies. “The biggest question for 2014: Will China manage to gently deflate the massive $24 trillion credit bubble built since the Financial Crisis with a skill that eluded the Fed in 1928, the Bank of Japan in 1990 and the Bank of England in 2007,” he writes, then noting the Federal Reserve component in the problem. “Tapering by the Fed only increases the odds of triggering world deflationary risks.”