"Virtually Everybody Knew This Was Coming"

Was it Turkey’s “executive presidency” and its unwillingness to hike rates in the face of soaring inflation? Or maybe the record global debt accumulated over the past decade? Maybe the artificially low interest rates? Or perhaps it was the pervasive current account deficits amid easy outside capital. How about the rapid slowdown in China, its escalating trade war with the US, and the Yuan devaluation? Or perhaps it’s just the rising US interest rates and global quantitative tightening soaking up billions in excess liquidity?

However one justifies the current emerging market crisis, one thing is clear “virtually everybody knew this was coming.

At least that’s the common theme according to SocGen’s Albert Edwards, who after an extended absence has returned, with a new note looking at the turmoil gripping the EM sector. It’s hardly new territory for the SocGen strategist, who prior to his current role, was most famous for his correct predictions and observations on the Asian Financial Crisis of 1997.

Fast forward some 21 years, when the veteran SocGen strategist believes the current turmoil boils down to two things: the Fed’s ongoing tightening – a point we discussed earlier this week in “Forget About Turkey: Asia Is The Elephant In The Room” – and China’s rapid devaluation. Turmoil, which as Nedbank noted previously, is about much more than just Turkey, which is merely the symptomatic “tip of the iceberg.”

Here’s Edwards’ take on where we stand:

Many commentators have thought for some time that Turkey was a macro-accident waiting to happen. But the key issue is not Turkey’s idiosyncratic macro problems. The unfolding crisis in EM is the direct result of Fed tightening and the strong dollar. The Fed always raises rates until something breaks. But Turkey breaking will not be enough to derail this Fed’s tightening mission. But what is the significance of China’s ongoing devaluation in the face of rapidly weakening growth and trade tensions? Is that also playing a role in draining global liquidity from the financial markets?

And speaking of Turkey, nothing that is taking place now should be a surprise: after all, until the recent diplomatic spat, all the same trends were in place – sliding currency, rising inflation, surging USD-denominated debt, gaping current account deficit…. In fact, if one did not see the Turkey crisis, they should probably look for a job outside of finance (like this Barclays bond trader for example). This is how SocGen’s Alvin Tan summed up the current crisis in Turkey:

“A textbook currency crisis is unfolding in Turkey. Large and widening current account deficit, check. Growing foreign currency debt, check. High and rising inflation, check. Constrained monetary policymaking, check. Just as King Canute could not stem the waters by ordering the tide to stop, a country with a 6% current account deficit and 15% inflation will be powerless to stop its bonds and currency sliding without hiking interest rates and/or restricting capital outflows. The triggers may be unique, but the crisis in Turkey is all too familiar, and the required policy response is too.”

What’s more, Edwards says that in the same way that the Asian crisis and the subsequent 1994 Mexican Peso (Tequila) crisis were wholly predictable, so too was this crisis, even though Turkey’s has a unique vulnerability has stood head and shoulders above other EM countries for some time, the same one we discussed in “16 Billion Reasons Why Turkey’s Currency Crisis Will Become A Debt Crisis.”

As we first noted yesterday, Edwards echoes that “Turkey has discovered that high and rising foreign-denominated debt never sits well with a huge current account deficit and a reluctance to raise interest rates.”

And while there is no easy way out for Turkey, especially with some $16 billion in in USD-denominated debt maturing by the end of 2019 and an economy in which rate hikes are forbidden…

… in the bigger picture this is not about Turkey or even EM. It is – as Edwards points out – “as always, about the Fed. But what is China’s role in all this? Are we missing something important in focusing too much on the Fed and the US dollar?”

Edwards answers these questions, and start by focusing on Turkey, not because of some obsession but because the country truly combines all the worst possible aspects of a distressed emerging market nation: not only the soaring foreign-denominated debt…

… but also that the current account deficit has remained stuck at 6% of GDP. And as an added kicker, there is a cartoonish self-appointed dictator to boot.

In this context, Edwards writes that “when you are relying on the “kindness of strangers”: to fund this deficit, it is best not to try and invent a new form of economics in which the higher interest rates needed to restrain a rampant credit bubble and defend the currency are deemed politically unacceptable.

Alas, that is precisely what Erdogan has been doing, and not just for the past few years, but for over a decade. Meanwhile, the unfolding EM crisis has been building up for years, and just as investors ignored the naysayers in the run-up to the Global Financial Crisis (GFC), they have ignored the IMF and BIS, who have been cautioning for some years about the explosive build-up in EM debt and especially dollar-denominated debt (see charts below).

Edwards makes some further points on the ticking time bomb that is growing foreign debt ownership for any EM nation:

According to the BIS, total dollar-denominated debt outside the U.S. reached $10.7 trillion in the first quarter of 2017, and about a third of this debt is owed by the EM nonfinancial sector. EM specialists, the Institute of International Finance (IIF), have also warned about this build-up in EM foreign-denominated debt. They too note that the EM corporate sector has been leading the explosion of debt, with Turkey standing out for the increase in its exposure since the GFC (see charts below).

Turkey has never managed to escape membership of “The Fragile Five” EM country club. These, the most macro-vulnerable of EM countries, wobbled badly during the 2013 Taper Tantrum when the then Fed Chair Bernanke floated the idea of Quantitative Tightening. Yet the other members of “The Fragile Five”, Brazil, South Africa, Indonesia and India, have to a greater (Indonesia) or lesser (South Africa) extent shuffled away from their perilous situation, leaving Turkey as the standout accident waiting to happen.

But did these charts just now appear? Was the Turkish crisis as much a surprise as the collapse in the Turkish Lira would make it seem? Not at all, but there was always the Fed’s soothing promise to never allow rates to rise to fast that let a generation of EM “experts” go to bed at night, certain of the knowledge they would see their carry trades implode in the middle of the night. That has now changed. Here’s Albert:

Let’s face it: virtually everybody knew this was coming. But in the frantic QE-inspired hunt for yield, no-one cared. And this is always the problem while liquidity is washing through the financial markets because of loose money polices (usually centred around the Fed).

It’s not just that the Fed which set the ticking time bomb below the entire emerging market: it’s also the certainty of the bulls that nothing bad could ever again happen, as “almost no-one is interested in heeding the pessimists and positioning of the inevitable financial market blow-up when eventually excessively loose monetary policy is belatedly tightened” Edwards laments.

Investors, drunk on the elixir of free money, think the good times will roll on forever. And even if they are cautious, a few quarters of underperformance usually invites either capitulation or being fired. With few exceptions, being too early with a bear call is usually a career ending decision. Better to stay in the crowd, remain fully invested and go over the cliff with the herd.

But besides complacent investor behavior, the Fed’s policies had a far greater impact on something even more important: dollar liquidity.

While US rates were low and the dollar was weak, the global carry-trade was a “no-brainer” (borrowing from US$ and investing in EM bonds). Then, as this year began, the dollar resumed its upward march after a 2017 pause, fuelled both by widening interest differentials in favour of the US and President Trump’s belligerent tariff talk. This has been a key ingredient in the stress on EM, because of their huge exposure to dollar-denominated debt.

The so-called “dollar shortage” has become a hot topic as EM companies scramble to unwind their dollar debt. Indeed, Raoul Pal, the keynote speaker in our January London 2017 Conference spent virtually his entire presentation talking about the coming EM crisis and the dollar shortage. But extreme long dollar positioning and a series of dovish Fed rate hikes took the steam out of the late-2016 dollar surge, and its further ascent was postponed until this year. But make no mistake, what we are seeing is exactly what Raoul predicted “a disorderly unwind of the global carry trade.”

Here Edwards repeats one of our favorite sayings, namely that the key for most commentators on whether the risk dominoes will continue to fall is the Fed tightening cycle. “To repeat: 10 of the last 13 Fed tightening cycles have ended in recession.”

Of course, no-one knows how much tightening will cause a recession this time around, or perhaps nobody really cares, because after a decade of doves in the Fed, few think that Fed will follow up its hawkish comments with the rate hikes it wants to deliver, especially if there is a market crash in the process. To Edwards, “part of this is baggage from the Bernanke and Yellen Feds who consistently over-promised and under-delivered.”

But many commentators, including myself, think that the Powell Fed will deliver rate hikes and that the strike price for the Powell equity put is far lower that it was for Greenspan/Bernanke/Yellen (ie, how much equity market weakness is the Fed prepared to tolerate before cutting rates). Powell is not one to freely allow the equity tail to wag the policy dog.

To be sure, it’s hardly rocket science to blame convulsing emerging markets on Fed policy, US interest rates, and a strong dollar. What else can there be, or as Edwards asks, “apart from Turkey-specific issues, has there been anything else that has triggered the immediate EM crisis that we should be watching closely?”

The answer to that is yes, China.

As we first discussed earlier this week, economic data reported by China has been progressively weaker culminating in this week’s abysmal data dump which missed across the board.

Even in the context of recent months the recently released July data were shockingly weak. Commenting on the Chinese slowdown, SocGen’s Wei Yao said that “in July, retail sales growth slid from 9.0% to 8.8%, or from 7.0% to 6.5% in real terms. In particular, retail sales of autos remained in contraction (-2.0%) and overall car sales dropped by 4.2%.” (see chart below, where I find it really is surprising how quickly REAL retail sales growth has decelerated).

Wei continues “Worse, there are signs that the labour market is starting to be affected by the economic slowdown. The surveyed unemployment rate edged up from 4.8% in July to 5.1%, a return to the March level. This was probably the most alarming data in July for policymakers.”

Edwards then shows the two charts we used in our latest observations on China’s ongoing credit impulse slowdown, which is taking place despite solid new loan creation, largely as a result of the ongoing collapse in China’s shadow banking sector.

But it’s what’s happen on the currency front that may be most interesting: according to Wei, “the central bank sent on 3 August the clearest signal so far of its dislike of large currency devaluation, as it re-introduced the 20% required reserve ratio on onshore currency derivative trading, thus making shorting the renminbi more expensive. This action taken at the time of still manageable capital outflows confirms our long-held view that devaluing the renminbi is not a tool that the Chinese government is willing to use lightly.”

Notwithstanding one’s opinions about whether the PBOC is or isn’t actively devaluting, the renminbi (RMB) is declining at an unusually fast pace compared to recent history, and according to Edwards, “this can’t just be market-related; if the Chinese authorities have moved into easing mode and begun lowering interest rates the currency will inevitably fall” and continues:

I certainly have been surprised by the pace of the renminbi decline since mid-year. At the time of writing the offshore rate is RMb6.95, only a tad above its early 2017 lows. In a few short weeks, the renminbi has lost all of its 18 months of gains, which in turn saw it recapture virtually all of its post Aug 2015 devaluation losses (see charts below).

Here Edwards highlights one notable difference from the 2015 devaluation: the speed with which the renminbi has tumbled, and has kept pace with other regional currencies, perhaps thanks to China’s relatively new FX basket.

What is significant to me is that the behaviour of the RMB seems very different now to that around the time of the Aug 2015 devaluation. We were writing then that the Abe-inspired slump in the yen had dragged down other regional Asian currencies (especially during H1 2015 see chart below), and that ultimately the Chinese authorities would be ‘forced’ to participate in a competitive devaluation – albeit grudgingly. The situation was not dissimilar in the run-up to the 1997 Asian crisis, which also had mega-yen weakness as a trigger.

One can see from the chart above the sharp downward move in the Korean won and the JPM EM FX Index before China devalued in August 2015, and that even after the devaluation the RMB declined in a much more subdued manner than its competing currencies.

Contrast that with the more recent plunge in the RMB, which is every bit as rapid as other regional currencies, if not more so. Kit Juckes has even just shouted to me from the other side the room that the RMB might be leading the way down in the region.

Which bring us to the conclusion, and the question which Edwards believes no-one is asking: is the entire house of Emerging Market cards about to topple, and is China – the dynamo behind the world’s EM (and DM) growth – losing control of its economy and using the RMB as a cushion?

“No-one is asking this question because we have got so used to the China naysayers (such as myself) being wrong that we dismiss their worries out of hand nowadays”, Edwards surmises.

And in the very next sentence, he leave with some ominous words: “that is the same complacency that we saw during the run-up to the 2007 financial crisis and indeed in the run-up to the current Turkish crisis, which also defied the bears for so long until now.

Maybe, or maybe like BMO’s Ian Lyngen wrote yesterday, the tightening is almost over, inflation be damned – after all, the Fed has repeatedly admitted that inflation is a “mystery” to its Econ PhD inhabitants – and not only is quantitative tightening set to end, but the next QE is on deck as soon as one year from today.

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