Macro: The Bottom Line (1/27/2014)

Don't cry for me Argentina

EM has started off the new year in the doldrums ...

 

For those who felt that 2014 would be nothing more than a mere continuation of 2013 - steady improvement in the US economy, strong corporate earnings and blockbuster equity performance, continuation of Fed tapering etc. - last week's EM "double-whammy" certainly represented a rude awakening.

First, there was HSBC's manufacturing Purchasing Manager Index (PMI) report on China, essentially a barometer for business confidence in the world's secod largest economy. Though markets were expecting somewhat of a cooldown in sentiment, nothing prepared them for the PMI to drop below 50 - the dividing line between "expansion" and "contraction" territory. At a time when concerns about Chinese growth remain widespread, this report certainly struck a raw nerve.

Second, Argentina allowed its peso currency (ARS) to depreciate intraday by the most in over a decade. By market close on Thursday, ARS had depreciated past 8 per USD (for context, at the start of January one USD bought just 6.5 pesos). Now, you may be asking: why all the paranoia about Argentina, a country that's already been a financial pariah for 13 years and a known no-go destination for most investors? The reason is, it's not about Argentina at all. Rather, It's about how symptomatic Argentina's problems are of the still-investable emerging markets: Turkey, Indonesia, South Africa, India etc.

You see, the reason the ARS has been on a slippery slope has to do with Argentina's persistent external imbalances. On the one hand, the country needs a large amount of dollars to pay for imports and to service its huge debt load. On the other, due to 25% inflation and a government with scant respect for property rights, few investors are supplying any dollars to the country, and Argentina's foreign reserves have been dwindling at a very fast pace. A perfect recipe to force your currency lower.

Now, the "still-investable" countries I listed above share many of the same characteristics as Argentina. They're all facing current account deficits (aka. income leaving the country exceeds income coming into the country). Some, especially Turkey, also have perilously thin international reserve buffers with which to defend their currencies. For now, the one thing keeping these countries afloat is the fact that they still have access to international markets - i.e. foreign investors are still willing to put their money there for the time being. But any prolonged crisis of confidence could change that very quickly...

Our view continues to be as we outlined in our last macro post in 2013: it's important to differentiate between individual emerging economies. Focus your investments on those that are pursuing structural reforms, laying the foundations for sustained growth, and have a large stock of international reserves (China, Mexico, or if you're ready to stomach some more volatility, Brazil). Steer clear of the likes of Turkey, Indonesia, India, and South Africa - these countries remain far too much at the mercy of international investor sentiment, with insufficient tools to cushion the impact of boom and bust cycles. While none of them are quite Argentina yet, several of them are certainly moving in that direction.