EM Money Flow Model: Center to Periphery
A framework for EM Currency Analysis
The Center (key developed nation capital markets) provides liquidity flow (in the form of demand for goods, investment funds, foreign direct investment, direct bank lending, etc) to the Periphery (developing/emerging nations of the world).
...therefore what follows...
The Periphery as a block tends to prosper primarily from global growth and low volatility (i.e. a belief in the prospect growth will proceed and relative risk is contained).
...and because the Periphery tends to lack domestic sources of private capital (those that do tend to weather storms better)...
The Goal is to do our best to monitor money flow to the Periphery (and progress on local capital market developments) in order to help determine relative demand for emerging/developing market currencies and whether current price trends are sustainable from a flow basis.
Black Swan Capital EM Money Flow Model
This is a two-way circular flow...Self-reinforcing spiral!
Analytical Tools Include:
- EM stock markets - the stock market is a valuable source of collateral for EM countries and represents the key source of speculative capital flow to EM countries by global investors seeking the highest capital gains opportunities. By virtue of speculators buying a country's stock market, they are effectively buying its currency.
- S&P 500 VIX- A good measure of stock market volatility; stock markets are increasing correlated globally thanks to globalization and the US market is the largest repository of risk capital in the world.
- Credit spreads - A good direct measure of specific credit risk perceived by bond investors i.e. fixed income money managers. The spread between riskier bonds and US Treasuries is defined as the credit spread. There is a credit spread for various classes of bonds compared to US Treasuries; we will focus on emerging market bond index spread.
- Yield differentials - The relative high yield offered by EM countries relative to the industrialized world is often a powerful driver for short-term speculative capital seeking high returns in short-term deposits. And relative decline in EM country yields might also be a reflection of easier credit conditions and falling inflation rates; thus we will examine not only nominal yields, but also real yield after account for inflation i.e. Real Yield = Nominal Yield - Inflation Rate
- Commodities - Many EM economies are highly dependent on commodities demand to drive economic growth i.e. global demand for commodities is a primary driver of EM exports. This is why you tend to see the relative value of EM currencies moving directly in line with commodities prices, either up or down.
- Industrial production-This is a monthly number that can give us insight as to real growth, or trend of growth, relative to expectations in the market and needless to say is key to driving real wealth within an economy.
- Technical Analysis - Standard trend analysis to validate whether or not price action is validating or invalidating fundamental thematic and money flow analysis.
- Political Risk-Political risk analysis is a qualitative measure. But because EM's by nature have lesser developed political/social institutions, volatility in these areas can quickly flow into price. Assessing political risk is not about forecasting, but is about monitoring key news to assess ongoing risk.
A world of fluctuating exchange rates and large-scale capital movements is characterized by vicious and benign circles in which the 'normal' pattern of causation, as defined by classical economics, seems to be reversed: market developments dictate the evolution of the conditions of supply and demand, not the other way around.
George Soros - Alchemy of Finance
Ebb and Flow of Emerging Markets
Flash back to 2006 and 2007 when emerging market became the hottest of the hot investments. There was a rush to pump capital into emerging market assets for they were the future; they possessed unmatched growth potential and unmatched capital gain opportunity. In short, they captured massive amounts of capital flow. Industrialized economies - especially the US - were so yesterday. And after all, emerging markets were about to prove they had decoupled from the developed world industrialized economies-they had big current account surpluses and years of stair-step growth ahead.
That was until all things financial imploded, a la the global credit crunch. It was a key global sea change event that proved decoupling was a myth and the importance of the role developed world economies play in funding the emerging world i.e. the center sending liquidity out to the periphery. Thanks to massive deleveraging ushered in by the credit crunch, emerging markets were hammered across the board-stock markets, bond markets, and currency markets.
After watching money flee risky investments in emerging markets et al, we are again witnessing a fresh wave of speculation on emerging market potential. It's been a highly correlated global stock move, led by emerging markets with China as the lead dog.
Below is a slide showing the tight correlations-dollar down, while emerging market stocks (and currencies) and commodities power higher i.e. fueled on dollar-based liquidity. The green segment in the slide represents green shoots optimism. And the key drivers are Chinese growth and an expectation the worst of the recession is behind us and belief the developed world economies will continue to rebound. But risks remain, as Mr. US Consumer is still the primary global demand driver.
Emerging market stocks have surged 81% since the low in March-that represents a lot of optimism. Can you say bubble? Heck, the S&P is up a whopping 49% since its March lows, yet year-over-year earnings are estimated to be about 40% lower.
The term to describe this flow of investment capital is risk appetite - developed nation liquidity through speculative funds flow into risky asset investments, as you saw in the EM Money Flow Model above.
Risk appetite is increasing with every new development that moves, or even less ... points, the global economy towards a path to recovery. What is crucial now is to determine whether the improvement in risk appetite is a long-term trend ... or instead just a blip in what will be a continued run away from risk as commenced last year. For the emerging markets, specifically, the underlying economic risk plus global investor sentiment will together tell the story.
In other words, there are really two types of trading opportunities in emerging markets - global macro and country specific opportunities.
Emerging markets are still extremely susceptible to the ebb and flow of global capital and the sentiment of the international investment community. We refer to this all important money-flow dynamic as periphery to the center which is the core of money flow.
To reiterate, despite characteristically high exchange reserves (which tend to add up fast in the emerging world precisely because domestic investment opportunities are lacking) and overall improvement in emerging market fiscal conditions, these markets are still highly dependent on capital flowing from the developed world-the center-for two primary reasons:
1) Emerging markets still lack efficient functioning and liquid capital markets. They have no bond market or sophisticated derivatives market to fund growth. They do have the ability to raise new equity money through IPOs and direct investment, of course, but these are considered risky asset investments and tend to disappear as a source of funds when the developed world pulls back. We are in major pull-back territory as institutions and retail investors alike have begun the painful process of deleveraging, i.e. paying down debt. This means money flows out of risk assets and back to the center.
2) External speculative capital flow represents such an inordinate amount of capital relative to the existing capital base within the emerging world. Therefore, ebbs and flows of external investment capital tend to have a powerful impact on market price action during the rally phase, and an even more dramatic effect on the downside. These markets highly susceptible to the classic boom-bust price cycle pattern we see naturally in all traded asset markets.
This is the broader macro context.
Country-specific opportunities generally cannot be defined and pinpointed as precisely as global capital flows since national events, and their subsequent impact, vary from region to region. But it is important to look for indications that emerging markets may be on the verge of a major boom ... or major bust.
Because of their very nature, it is the potential for crisis in an emerging market economy on which a prepared investor can capitalize. This crisis-potential can usually be chocked up to political risk. These underdeveloped or extreme political systems can wreak havoc on local markets and economies.
Unnatural regime changes, nationalization and controls imposed on trade are among reasons why many emerging economies are susceptible to crisis-type market events. Yes, there's another side to this coin too - developing political systems could also provide very beneficial policies and incentives for economic growth. But considering the current global environment, and increasing government intervention, the probability for unwanted political interference or turmoil is rising despite the current growth optimism.
One more time: emerging markets are heavily dependent on global capital flow. This capital flows into their exports markets; it flows into foreign direct investment; it flows into commodities, a key source of wealth for so many emerging nations. It can be summed up in one word: demand.
Demand, mostly external demand, is the still the life force of emerging economies. That will change as domestic markets continue to grow and mature in the EM world. Now, we can say that growth potential is enormous in the emerging world, but risks remain. For long-term players it likely doesn't matter with a long-term low leveraged buy and hold strategy. Stay tuned.
Key Risk: Global Rebalancing - Can China continue to grow with anemic expectations from its major demand source the West?