Divergences Converge – Global Capital Flows Begin To Shift by Ashwin Bulchandani, MatlinPatterson
In our last letter, we drew attention to the gap between U.S. credit and equity markets that had been developing since June of last year, as previous such occurrences in 1998 and 2007 were particularly discomforting. That gap is now starting to close, mainly driven by the recent lurch downward by the U.S. equity market. The other divergence we highlighted – between the U.S. equity market and other global asset markets – has also started to close with great ferocity.
The stated catalyst for the U.S. equity market’s recent swoon seemed to be an acknowledgement by investors that Emerging Market (EM) equity declines can infect a healthy U.S. market. This occurs either via simple financial market contagion as people de-risk their portfolios, or via changing earnings expectations given that almost a third of U.S. corporate revenues are sourced from outside the U.S.
But, in our view, the proximate cause for the recent equity market weakness is the changing global currency framework. As currency pegs fall (Kazakh Tenge), or are deliberately weakened (China’s Yuan), it is becoming increasingly evident that patterns of global capital flows that prevailed prior to the 2008 credit crisis are starting to shift. An apparent calm prevailed while the Fed provided more and more liquidity to the global financial system, but once that Fed-supplied liquidity – lifeblood for the status quo – was removed, cracks began to appear in the financial bedrock.
David Einhorn's Greenlight Capital returned -2.9% in the second quarter of 2021 compared to 8.5% for the S&P 500. According to a copy of the fund's letter, which ValueWalk has reviewed, longs contributed 5.2% in the quarter while short positions detracted 4.6%. Q2 2021 hedge fund letters, conferences and more Macro positions detracted 3.3% from Read More
The most telling sign that we were all too dependent on Fed largesse was the Taper Tantrum of 2013 when the Fed announced that it could imminently reduce asset purchases, or, heaven forfend, even tighten liquidity conditions. Almost immediately, the U.S. Dollar rallied, rates rocketed higher, and Emerging Market bonds suffered a nasty downturn, including longer-dated Brazilian bonds, which fell more than 30 points. (An occurrence that allegedly led to some headline-grabbing West Coast personnel changes). The Indian rupee suffered a gut wrenching 20% correction that could only be arrested by its newly installed central bank governor – Raghuram Rajan – erstwhile chief economist of the IMF and Cassandra-esque foreteller of the credit crisis of 2008 (which led Larry Summers to then label him a “Luddite”). Given the global markets’ violent reaction to the Fed’s comments, itself a reminder of the system’s fragility, the Fed relented at its next meeting, and decided to postpone any plans to taper.
But almost 2 years later, the Fed has indeed tapered its purchases to zero, and we are possibly witnessing the market’s reaction to that massive liquidity withdrawal. Correlation is never causation, but the Fed’s cessation of asset purchases seems to have coincided almost too perfectly with the energy swoon, the credit market displacement and an underperformance of EM assets in general.
More recent occurrences in the currency market are perhaps the most telling sign of a reversal in global capital flows. Accused for years of being a currency manipulator, China relented and attempted to let its currency float ever so slightly in early August. Shockingly, the currency actually weakened. To some policymakers’ surprise, it appears that the “market” level for the Chinese currency is actually lower than where it was fixed by the Chinese authorities. That’s a mirror image of the situation only a few years ago when China’s intervention prevented a rapid firming up of its currency. But this time around China was intervening to strengthen its currency, rather than weaken it in an attempt to promote its hardly nascent export sector.
After China’s accession to the WTO in 2001, we saw developing nations deliberately keep their currencies weak (yes, they really were the original QE perpetrators), thereby stoking exports and ultimately economic growth. Any incipient strengthening pressure on their currencies was met with unabashed intervention and more open market U.S. Dollar buying (and resultant weakening of the RMB, BRL, KRW etc.), and those Dollars ultimately found their way back into U.S. assets. China’s ascent to the world’s largest holder of U.S. Treasuries was proof of this U.S. Dollar recycling.
But now that flow of U.S. Dollar liquidity has slowed. Money has started to leave the emerging markets and central bank intervention is conducted to control, even arrest, the local currency’s decline. At the risk of oversimplifying, U.S. Dollars are no longer being bought and recycled into U.S. Dollar assets, but rather, those assets are now being sold and the resulting liquidity used to constrain a too rapidly falling currency. In fact, almost a trillion Dollars have left the EM countries since June of last year. The most telling sign of this flow has been the recent backup in the Treasury market i.e. an increase in risk-free safe asset yields, when the world seems much less safe and a lot more risky. Yes, someone is indeed selling.
Not so Wealthy Sovereign Wealth Funds
A similar story is playing out with oil-producing nations albeit at a much earlier stage in the narrative. A rising oil price meant considerable Dollar flow into those countries – U.S. Dollars that were ultimately recycled into U.S. Dollar assets. However, as oil prices flirt with decade lows, that flow possibly reverses, but certainly decreases in magnitude, putting further pressure on asset prices. Witness Norway, custodian of the world’s largest sovereign wealth fund, which is budgeted to spend a greater share of its fund in 2015 than it did the previous year. But this was planned when oil prices were considerably higher than they are now. Of course, Norway and a host of other similar sovereign wealth funds will now have to contend with the fact that global asset prices are significantly lower than they were a year ago (the MSCI World Index is down almost 10% in hard currency terms since its highs), which will lead to some interesting vicious cycle math of its own.
Bonds Have More Fun
So what does this imply for asset prices? It certainly keeps pressure on global financial assets, which means we are back to finding those securities that generate a visible return i.e. a coupon. No longer can one broadly buy today in hopes of selling higher tomorrow. It’s time once again to seek out those assets that generate a “palpable” return – coupon in the case of financial assets or free cash flow in the case of corporate assets – for we can no longer rely on the rising tide of liquidity lifting all boats. Bonds, as they say, are back.
Chief Risk Officer