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Playing Russian roulette

The Russia and Ukraine geopolitical tensions have driven their asset prices since February. As the below research courtesy of BofA Merrill Lynch shows, investors’ base case scenario is that a major escalation of the conflict, in the form of a direct Russian invasion of parts of Eastern Ukraine, is unlikely. The possibility of an invasion seems analogous to Russian roulette, a low probability but high impact game.

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I just returned from a trip to Moscow. You would not know there is the possibility of a war going on next door by walking around the city, if you didn’t turn to the news. Its picture perfect spring blue skies were in stark contrast to the dark clouds looming over the economy.

The transmission mechanism of the political impact into the economy is fairly predictable:

  1. Political-related risk premia and volatility remaining elevated, translating into weakening pressure on the ruble;
  2. Pressure for higher rates as the ruble weakens (the CBR has already hiked rates by 200 bps, including the unexpected 50bps hike last week, but more will be needed if demand for hard currency remains at the Q1 2014 level and pressure on the currency increases further);
  3. Downside pressure on growth as investment declines and through the impact of sanctions or expectation of additional sanctions (through higher cost of capital);
  4. Downward pressures on international reserves as the capital account deteriorates and CBR smoothens the currency move;
  5. Decline of the oil reserve fund should it be used for counter-cyclical fiscal purposes or refinancing of maturing debt (the $90 billion fund could theoretically cover one year of amortizations, but in that case, capital flight and dollarization would escalate further as the risk perception deteriorates).

All these elements are credit negative and it is not a surprise that S&P downgraded Russia’s rating to BBB-, while keeping it on a negative outlook. What is less predictable, however, is the magnitude of the deterioration of each of these elements, which will be determined by political events and the extent of economic sanctions.

My impression was that the locals’ perception of the geopolitical risks was not materially different from the foreigners’ perception shown above – i.e. that a major escalation in the confrontation remains a tail risk. The truth is, there is a high degree of subjectivity in these numbers and an over-reaction from either side (Russia, Ukraine, the West) can escalate this fluid situation fairly quickly. The locals are taking precautionary measures, including channelling savings into hard currency (either onshore or offshore), some pre-emptive stocking of non-perishable consumer goods, considering alternative solutions should financial sanctions escalate – including creating an alternative payment system and evaluating redirecting trade into other currencies, to the extent it can. Locals believe that capital flight peaked in Q1, assuming that the geopolitical situation stabilizes. Additional escalations could occur around 1st and 9th of May (Victory Day), as well as around the Ukrainian elections on 25th of May.

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The table below assigns various CDS spread levels for each of the scenarios, with the probabilities given per the earlier survey. The weighted probability average is still wider than current levels, though we have corrected by a fair amount last week. I used CDS only as it is the best proxy hedge for the quasi-sovereign and corporate risk. Also, the ruble would be heavily controlled by the CBR should risk premia increase further, and may not work as an optimal hedge for a while, while liquidity on local bonds and swaps would suffer should the sanctions directly target key Russian banks.

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The risk-reward trade-off appears skewed to the downside in the near term.

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Video – some thoughts on emerging markets from Hong Kong and Singapore

I recently visited Hong Kong and Singapore to attend some conferences and meet clients in the region. While travelling, I put together a short video to share some of our views on Asian emerging economies and emerging markets in general.

As recently reported in Claudia’s Panoramic outlook here, following both the 2013 sell-off and the recent EMFX volatility experienced earlier this year, investors’ attitudes towards emerging markets have changed. Volatile capital flows, unsustainable growth models, a deterioration in current accounts, excessive credit growth and currency depreciation are key concerns for local and global investors. Some trends have become unsustainable and a rebalancing process has started. Emerging market economies will need to adjust to lower capital flows, with this adjustment taking place on various fronts over several years.

While adjustments take place, new opportunities present themselves. But not all emerging markets are equal. As emerging economies are on diverging paths, especially in Asia – some are deteriorating (eg China) while others are improving (eg Philippines or Sri Lanka) – asset allocation and stock selection will be key. Watch the video to find out our preferences.


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World Cup currency trading strategies: emerging vs. developed markets

With just under two months to go to the opening match and tensions already mounting within our team (we have 8 different participating countries covered – Australia, Brazil, England, France, Germany, Italy, Spain and USA), we thought it was time for a World Cup themed blog. Our prior predictor of the 2010 World Cup winner proved to be perfectly off the mark. Based on expected growth rates in 2010, we predicted that Ghana would win and Spain would come last – and we know what happened subsequently. However, in defence of the IMF, Ghana were the surprise package of 2010, only failing to reach the semis thanks to a Luis Suarez handball.

However, despite the tradition of ‘lies, damned lies, and statistics’, I still believe in analysing data and making predictions. Was it coincidence that the team that was not part of our predictions (North Korea), given the lack of available economic data, ranked last? Would Argentina have made it to the quarter-finals had it not been altering its inflation statistics?

Historically, the World Cup has been won 9 times by an emerging country and 10 times by a developed country. Will an emerging country win and tie the score this year?
We present two currency trading strategies associated with the World Cup:

  1. Arbitrage: in currencies with full convertibility or minimal transaction costs, arbitrage opportunities are very limited. However, currencies that are subject to restrictions on capital flows, taxation or regulatory requirements often offer arbitrage opportunities in excess of the costs associated with these factors. For example, for the World Cup in Brazil, ticket prices for non-residents are determined in USD and in BRL for Brazilian residents. Ticket prices were set by FIFA in May 2013 (1980 Brazilian Reals or 990 US Dollars for category 1 tickets), based on the prevailing US Dollar / Brazilian Real exchange rate of 2.00. As ticket prices remain unchanged in USD and BRL and given the depreciation of the Real since then, ticket prices in BRL are now 14% cheaper than tickets purchased in USD.1
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  2. Currency carry trades: a popular strategy which is relatively easy to implement and which has proven profitable2. We test the strategy by going long a basket of emerging market currencies of the qualifying countries (which are normally higher yielding due to higher inflation, economic risks, etc.) funded by a basket of developed market currencies of the qualifying countries (which are normally lower yielding, which has been exacerbated by quantitative easing). Out of the countries that qualified for the recent World Cups, we arbitrarily classify them as 18 emerging and 14 developed. However, if we measure them by currency, the numbers change slightly. A few emerging countries have a developed market currency as legal tender (for example, Ecuador adopted the US Dollar as its legal tender in 2000), so it makes sense to count them as developed countries. We keep Ivory Coast under the emerging basket, as the West CFA Franc, while pegged to the Euro, is not the same as having Euro as its legal tender.

We test our World Cup carry trade performance during the last 2 World Cups between January 1 (a clean start date once the 32 qualifying teams became known) and the start dates for each tournament.

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The EM vs DM FX carry trade posted a small profit in 2006 (+0.4%) and was a clear winner in 2010 (+2.4%)3 . On the football field, however, emerging market lost to developed market in both instances (Italy and Spain won). Ahead of the upcoming cup, the carry total return points to a loss on the EM carry trade so far (-2.8% to the 11th of April). On this basis, I predict that an EM team will win the cup in Brazil.

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1For a more complex example of score betting on World Cups, see http://elsa.berkeley.edu/~botond/szjrt.pdf.
2For an empirical discussion of emerging market carry trades, see http://www.nber.org/papers/w12916.pdf?new_window=1.
3For simplicity reasons, we have omitted bid-offer transaction costs from the calculations. Given that some of the smaller EM currencies are less liquid and have higher costs (in this case, one buy and subsequent sell), the results slightly overstate the returns of the EM long side. On the short side, we only included the Euro once, to maintain a “diversified” basket of developed currencies.

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The emerging markets rebalancing act

Over the past year, investors’ perception towards emerging market bonds changed from viewing the glass as being half full to half empty. The pricing-in of US ‘tapering’ and higher US Treasury yields largely drove this shift in sentiment due to concerns over sudden stops of capital flows and currency volatility. For sure, emerging market economies will need to adjust to lower capital flows, with this adjustment taking place on various fronts over several years.

Some emerging market countries are more advanced than others in the rebalancing process, while others may not need it at all. Also relevantly, the amount of rebalancing required should be assessed on a case-by-case basis, as the economic and political costs must be weighed against the potential benefits. Generally, the necessary actions include reducing external vulnerabilities such as large current account deficits (especially those financed by volatile capital flows), addressing hefty fiscal deficits and banking sector fragilities, or balancing the real economy between investment and credit and consumption.

In our latest issue of our Panoramic Outlook series, we examine the main channels of transmission, policy responses and asset price movements, as well as highlight the risks and opportunities we see in the asset class. Our focus in this analysis is on hard currency and local currency sovereign debt.

  

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Emerging market debt: 2013 returns post-mortem and themes for 2014

Emerging market (EM) fixed income posted its third negative performance year since 1998, driven by rising US Treasury yields, fears of tapering, and concerns around declining capital inflows from developed markets into emerging markets.  A number of EM countries were also hindered by country-specific drivers such as slowing growth, decreasing productivity, twin deficits, and exposure to a slowing Chinese economy.  EM fixed income still saw inflows for 2013 of $9.7bn, although this was way behind the $97.5bn inflows of 2012, and the asset class has seen outflows of around $40bn since May (source EPFR, JP Morgan).

Asset allocation and active duration management were key to performance in 2013

Within the asset class, EM corporate bonds outperformed EM sovereign debt, with the former returning -0.6% and the latter -5.3% in 2013. This sub-asset class benefited from its shorter duration and tangential spill-over (or higher correlations?) from the stronger performance in global investment grade and high yield credit. EM corporate bond spreads, measured by the JP Morgan Corporate EMBI index, are now flat to hard currency sovereign debt which translates into a narrowing of 66 bps since the beginning of 2013.

Therefore, the asset allocation between EM sovereigns in both hard and local currency and EM corporates was one of the key calls for performance in 2013. Sovereign bonds underperformed over the year, with hard currency debt delivering a negative return of -5.3%, also due to the fact that it has the longest duration of all three sub-asset classes. However, local currency debt faced a particularly challenging year, delivering a negative total return of -9.0% which can be mostly attributed to the foreign exchange component of the bond, while the carry, i.e. the additional return due to higher local interest rates, compensated for the back-up in yields.

It is worth though having a closer look at the underlying dynamics as it helps to further understand the drivers of performance in 2013 and how 2014 will be different.

1) Most of the negative return of EM hard currency sovereign debt was driven by rising US Treasury yields and less by the perceived deterioration in EM credit profiles and widening of EM spreads.
The negative impact of widening credit spreads was modest, contributing -0.5% to the total return of hard currency sovereign debt as the chart above shows. To put this into perspective, spreads widened by 50 bps in 2013, while 10 year US Treasury yields backed up by 116 bps. Hence, duration management was key in 2013. With tapering priced in and the US Treasury forward curve pricing 10 year US Treasury yields at around 3.5% by year end, an additional backup in US rates should be less pronounced in 2014 than it was in 2013. The risk to this outlook is for stronger than expected data and/or worsening of inflation expectations, which is not priced in at the moment. That is, a bear flattening of the US curve through pushing forward the anticipated hikes in the Fed Funds rate (currently priced for 2015 and beyond) is a risk to be monitored carefully.

The hard currency sovereign debt performance of stronger EM countries was not necessarily better

2) The performance of hard currency sovereign debt was not necessarily better for countries that are perceived to be more resilient, i.e. have lower debt levels, stronger liquidity, fiscal and current account position, sustainable growth as well as reform momentum, than for those that are perceived to be more vulnerable.
Let’s take Mexico, one of the stronger emerging market economies, and South Africa, an increasingly vulnerable emerging market country, as an example. Mexican government debt denominated in hard currency returned -7.1%, while the total return for South Africa’s government bonds stood at -6.9%. One explanation is that the channel of adjustment in the current account deficit countries is weaker currencies and/or higher interest rates which may not be such a negative factor for sovereign debt spreads. Countries that allow for a free floating currency minimise net international reserve losses, which is supportive for the performance of hard versus local currency debt. In fact, the major performance difference between these two countries was precisely on their local currency debt (see below), where Mexico justifiably outperformed South Africa.

3) Another characteristic of 2013 was the outperformance of those bonds associated with higher credit risk, such as high yielders and frontier markets.
The JPMorgan Next Generation Markets Index (NEXGEM), an index for frontier market sovereign bonds rated BB+ and lower, returned +5.1% in 2013. This may seem counterintuitive given the recent change of sentiment towards EM assets, but it is refreshing that the market differentiated between the various emerging market issuers and rewarded the stable or improving credit profile of the weaker issuers with positive returns and re-priced deteriorating stories into negative returns. Argentina, for example, returned +19.1% on the delayed court decision regarding the holdouts, as well as on expectations for better economic policies with a new government in 2015. Venezuela, on the other hand, returned -12.3% on continued growing macroeconomic and political imbalances. In addition, Eichenberg and Gupta find that countries which allowed for large increases in their current account deficits and for a sharp appreciation of their currencies, saw indeed a stronger valuation correction, but also suggest that bigger and more liquid emerging markets experienced, generally speaking, more pressure on currency and debt valuations. Identifying the critical bottom-up, idiosyncratic factors was hence key in 2013 and will remain so in 2014, given the large rally we have seen in most of these frontier market bonds and, therefore, less favourable valuations.

Weakening EM currencies provided the strongest headwind for the asset class

4) Local currency debt was the key underperformer.
The bulk of the losses in emerging market debt issued in local currency was due to currency depreciation, which was one of the key transmission mechanisms in 2013 to potential lower capital flows into emerging markets. As such, various currencies will continue their move to fair value or undervaluation, if warranted, through 2014 as well. An eventual narrowing of current account deficits in countries that require an adjustment but do not face major structural rigidities, such as Brazil, India or Indonesia, should slow the depreciation pressure and, thus, performance in 2014 should not be as negative. That is, the balance of risks and market focus should then be centred on the capital account.

5) Positive carry and a lower duration have provided an anchor of support for local currency debt returns.
Local currency yields rose by 135 bps in 2013 to 6.85%, driven by currency weakness (South Africa), monetary policy tightening (Brazil, Indonesia), fiscal deterioration and inflation risk (Brazil), political and external account concerns (Turkey), as well as a higher floor from US yields. The carry, however, and a lower average duration on local currency debt, for which a comparable index has a duration of 4.6 years, allowed for the total return in local currency terms to be flat in 2013 and provide a better cushion for 2014.

6) Political risks were pretty muted in 2013 (with a few exceptions), but are likely to increase significantly in 2014.
Though countries like Turkey and Ukraine as well as the Middle East faced serious political crises, politics did not play a major role for the asset class in 2013. However, 2014 will be a year in which the return impact from idiosyncratic political events in emerging markets could increase substantially. Twelve of the major emerging market countries will have presidential and/or parliamentary elections, including all the ‘fragile 5’ countries, i.e. Brazil, India, Indonesia, South Africa and Turkey – and we will comment in more detail on this in a forthcoming blog closer to the election dates. The prospect of these elections could potentially reduce the net capital flows into these economies on a temporary basis, such as through local capital flight, delayed foreign direct investment (FDI) and/or portfolio flows as well as increased demand for foreign exchange (FX) or credit default swap (CDS) hedging etc., pending the outcome of the elections and subsequent prospects for future economic policy and support for reforms.

In summary, the asset allocation between EM sovereigns in both hard and local currency and EM corporates should be less important in 2014 than it was in 2013, given that the forward yield curve implied levels for US interest rates is already pricing 10 year yields in the mid 3% range. Furthermore, the relative value opportunity between these three asset classes has decreased after the underperformance of sovereign debt in 2013 and the narrowing of EM corporate bond spreads on the back of  the rally in global credit in both the investment grade and high yield space. In addition, valuations for local currency debt look better, also on the basis of the exchange rate adjustments seen in 2013 and higher yields. In other words, we expect the difference on performance, on aggregate, to be more muted at the top down level.

On the other hand, idiosyncratic EM events, including political events, will become more relevant, which makes bottom up security selection and timing, i.e. the repositioning through bouts of volatility, even more critical in 2014 . Global macro factors and drivers of global risk appetite, such as economic growth and inflation, China’s rebalancing efforts, commodity prices as well as developments in the Eurozone, will remain equally important.

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A quick look at Asia: corporate fundamentals and credit tightening

As Mike just reported, we remain concerned with a number of internal issues as well as external vulnerabilities facing emerging markets. With economic growth fuelled by excessive credit growth, deteriorating current account balances and potential contagion risk if the Fed tightens monetary policy (leading to capital flows back to the US and Europe), another big sell-off can certainly not be ruled out. Combining the above with what are now fairly unattractive valuations, the overall macro EM story continues to be a none too compelling one for us.

However, what do we think of the situation at the company level? As a counter-argument to our cautious macro-economic outlook, a number of EM companies possess solid balance sheets despite their home country’s economies often being stuck in quicksand. Why not invest in solid EM-based multinationals if they have strong balance sheets, solid cash flows, sizeable global market share in their segment and an ability to diversify their revenues internationally? Let’s take a closer look.

Focusing on the Asian corporate world specifically, this last “stronghold” seems to be collapsing as corporate fundamentals have sharply deteriorated. A worsening economic outlook, slower growth and tighter credit availability from the banking system will create challenges. Leverage has picked up as companies have both taken on more debt and burnt cash (a trend most evident in high yield issuers compared to investment grade). A number of Asian corporates have leveraged up in foreign currencies (mainly USD) while having revenues in local EM currencies, thus becoming increasingly vulnerable (where FX is not hedged) to a potential strengthening of the US Dollar. Operating margins (EBITDA) are flat, and capex has sharply decreased. While reduced capex may be good news for creditors in the short term (other things being equal) as more resources become available to pay back debt, it is not a great foundation to build a company’s future: how do you sustain a business over the long term if you don’t invest? On the other side of the coin, this trend of reduced capex does at least provide some evidence of emerging balance sheet discipline after years of easy credit.

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Across EM as a whole, bank loan growth has been broadly unaffected by the crisis in the summer. It was running at a pace of USD 160bn per month in July and August (according to JP Morgan data), the same rate as earlier in the year. However, looking at Asia specifically this is not the case. Despite financial conditions still being in accommodative territory (apart from India and Indonesia, no other Asian EM has hiked rates since mid-2011) a problem of over-leverage – driven by China – is pushing a number of Asian banks to close their wallets. Credit availability via official bank loans (and importantly the shadow banking system in China as well) has not been an issue so far, but corporates will have to rely on bond markets to a greater extent going forward. However, will domestic and international bond investors support deteriorating balance sheets in weakening economies? If not, we should expect to see more defaults next year, bearing in mind that Asian high yield defaults have already increased from an annual rate of 0.8% in early 2013 to 1.8% recently.

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Is it only bad news then? Not entirely. Some EM companies will benefit from a stronger USD (exporters specifically) as they will gain competitiveness through being able to offer cheaper goods to the US and Europe, which are expected to grow in the coming years. Also, company specific factors including improving liquidity, stronger cash flows and stabilising balance sheets, especially in the investment grade space, may mitigate some of these concerns. And at the end of the day everything has a price in the market. We think many of the concerns we have highlighted here have been priced in to a certain degree, and while EM corporate spreads have compressed back toward US and EUR corporate spreads since the end of August, they remain well off the pre-May levels. Stock-picking and a clear differentiation between good EM and bad EM, good companies and bad companies, will be the main determinant of performance next year.

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Will the Fed push EM over the edge?

We’ve been very worried about emerging markets for a couple of years, initially because of surging portfolio flows, better prospects for the US dollar and historically tight valuations (see The new Big Short – EM debt, not so safe, Sep 2011). But increasingly recently our concern has been driven by deteriorating EM fundamentals (see Why we love the US dollar, and worry about EM currencies, Jan 2013). A combination of miscommunicated and misconstrued Fed speak in May brought things to a head, and EM debt crashed in May to July (see EM debt funds hit by record daily outflow – is this a tremor, or is this ‘The Big One’? Jun 2013), although the asset class has since recovered roughly half of the losses. So where are we at now?

First up, fund flow data. Outflows from EM debt funds abated in July and August, briefly turned into inflows in mid September immediately following the non-tapering decision, but have since broadly returned to outflows (see chart below). Outflows from EM debt funds since May 23rd have been a very chunky $28bn, over $3bn of which have come since September 23rd.

However, as explained in the blog comment from June, EPFR’s now much-quoted fund flow data only apply to mutual funds, and while you get an idea of what the picture looks like, it’s only a small part of the picture. Just to emphasise this point, it has now become apparent that a significant part of the EMFX sell was probably due to central banks. The IMF’s quarterly Cofer database, which provides (limited) data on reserves’ currency composition, stated that advanced economy central banks’ holdings of “other currencies” fell by a whopping $27bn in Q2, where much of this ‘other’ bucket is likely to have been liquid EM currencies. Maybe half of this fall was driven by valuation effects, but half was probably dumping of EM FX reserves. Limitations of the EPFR data are also apparent given that there has been a slow bleed from EMD mutual funds this month, but that doesn’t really tally with market pricing given that EM debt and EM FX have been edging higher in October. An increase in risk appetite among EMD fund managers could account for this differential, although it’s more likely that institutional investors and other investors have been net buyers.

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A relative stabilisation in fund flows doesn’t mean that planet EM is fine again. The recent IMF/World Bank meetings had a heavy EM focus, which followed on from the negative tone towards EM in the latest editions of the IMF’s flagship World Economic Outlook and Global Financial Stability Report (GFSR). The IMF again voiced concerns about the magnitude of the EM portfolio flows, and the chart below suggests that flows have deviated substantially from what the IMF believes is a gentle trend upwards in investors’ allocation to EM. A reversal of recent years’ inflows back towards the long term trend level would cause considerable pain, and while $28bn of outflows since May 23rd may sound like a lot, this is only equivalent to the inflows in the year up to May 23rd, let alone the inflows from the preceding years. As explained in Chapter 1 of the GFSR, which is highly recommended reading, foreign investors have crowded into local emerging markets but market liquidity has deteriorated, making an exit more difficult.

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What now for EM debt? Your outlook will likely depend on how you weight and assess the different performance drivers for the asset class. There has been a heated debate in recent years on whether emerging market portfolio flows are driven primarily by so called ‘push factors’ (eg QE and associated negative developed country real interest rates pushing capital into countries where rates are higher), or whether flows are driven by ‘pull factors’ (eg domestic factors such as reforms or financial liberalisation). EM countries have tended to argue that push factors dominate, with Brazilian Finance Minister Mantega going as far as to accuse G3 policymakers of currency manipulation, while Fed Chairman Bernanke and future Chairman (Chairperson?) Yellen have argued that EM countries should let their currencies appreciate, although a recent Federal Reserve paper highlights both push and pull factors.

Number crunching from the IMF suggests that it is the EM policy makers who have the stronger arguments. In April’s GFSR, the IMF’s bond pricing model indicated that stimulative US monetary policy and lower global risk (itself partly attributable to the actions of advanced economy central banks) together accounted for virtually all of the 400 basis point reduction in hard currency sovereign debt from Dec 2008-Dec 2012, as measured by JP Morgan EMBI Global Index. Meanwhile, external factors were found to have accounted for about two thirds of the EM local currency yield tightening over this period. ‘Push factors’ therefore appear to dominate ‘pull factors’, something I agree with and have previously alluded to.

The relevance of external factors shouldn’t be a major surprise for EM investors given that the arguments are not remotely new. Roubini and Frankel have previously argued that macroeconomic policies in industrialised countries have always had an enormous effect on emerging markets. Easy monetary policy and a low global cost of capital in developed countries (as measured by low real interest rates) in the 1970s meant that developing countries found it easy to finance their large current account deficits, but the US monetary contraction of 1980-2 pushed up nominal and real interest rates, helping to precipitate the international debt crisis of the 1980s. In the early 1990s, interest rates in the US and other industrialised countries were once again low; investors looked around for places to earn higher returns, and rediscovered emerging markets. Mexico received large portfolio inflows, enabling it to finance its large current account deficit, but the Fed’s 1994 rate hikes and subsequent higher real interest rates caused a reversal of the flows and gave rise to the Tequila Crisis.

High real interest rates were maintained through the mid 1990s, the US dollar strengthened. Countries pegged to the US dollar lost competitiveness, saw external vulnerabilities grow and in 1997 we had the Asian financial crisis. In 1998, Russia succumbed to an artificially high fixed exchange rate, chronic fiscal deficits and low commodity prices (which were perhaps due in part to the high developed country real interest rates). A loosening of US monetary policy in the second half of 1998 alleviated the pressure on EM countries, but a sharp tightening in US monetary policy in 1999-2000 was arguably the final nail in the coffin for Argentina, and only IMF intervention prevented the burial of the rest of Latin America. The low US real interest rates/yields that have been in place ever since 2001-02 and particularly since 2009, together with the weak US dollar, have sparked not only large, but also uniquely sustained, portfolio flows into EM. [This is of course a gross simplification of the crises of the last 30 years, and there were also numerous domestic factors that explained why some countries were hit much harder than others, but it's difficult to dispute that US monetary policy has played a major role in the direction of capital flows on aggregate].

It’s starting to feel like Groundhog Day. Soaring US real and nominal yields from May through to August were accompanied by an EM rout. The tentative rally in EM over the last month has been accompanied by lower US real and nominal yields. Correlation does not imply causation, but investors should probably be concerned by the potential for US nominal and real yields to move higher as easy monetary policy is unwound. The date for the great monetary policy unwind is being pushed back, with consensus now for US QE tapering in March 2014, and if anything I’d expect it to be pushed back further given that it is hard to see how we’re going to avoid a rerun of the recent US political farce early next year. But this should only be a postponement of US monetary tightening, not a cancellation.

This year has been painful for EM, but it has been more a ‘spasmodic stall’ in capital flows rather than a fully fledged ‘sudden stop’. If, or perhaps when, the day of reckoning finally comes and US monetary policy is tightened, EM investors should be very concerned with EM countries’ growing vulnerability to portfolio outflows and ‘sudden stops’. [Guillermo Calvo coined the phrase 'sudden stop', and he and Carmen Reinhart have written extensively on the phenomenon, eg see 'When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options (2000)']

History suggests that a good old fashioned ‘sudden stop’ would be accompanied by banking and particularly currency crises in a number of countries. There are numerous variables you can use to assess external vulnerabilities, and many people have been busy doing precisely that since May (eg see the Economist or a writeup on a piece from Nomura). In January I highlighted some of the lead indicators of EM crises regularly cited in the academic literature, namely measures of FX reserves, real effective exchange rates, credit growth, GDP and current account balances.

To be fair, a few of these crisis indicators are pointing to a slight improvement. Most notably, FX reserves are on the rise again – JP Morgan has highlighted that FX reserves of a basket of EM countries excluding China fell by $40bn between April and July, but that decline was fully reversed through August and September, even accounting for the fall in the US dollar (which pushes up the USD value of non-USD holdings).

Currencies of a number of EM countries have seen a sizeable and much needed nominal adjustment, although it’s important to highlight that while nominal exchange rates have fallen, the fact that inflation rates tend to be a lot higher in EM than in DM means that real exchange rates have dropped only perhaps 5% on average, which still leaves the majority of EM currencies looking overvalued and in need of significant further adjustment. In particular, Brazil has much further to go to unwind some of the huge appreciation of 2003-2011. Venezuela looks in serious trouble, which is what you expect given it is trying to maintain a peg to the US dollar at the same time as its official inflation rate has soared to 49.4% (Venezuela’s FX reserves have halved in five years, and are at the lowest levels since 2004).

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However some of these lead indicators are just as worrying as they were in January. While the rapid credit growth rates of 2009-2012 have eased a little in most countries, perhaps partly on the back of weaker portfolio flows, there’s no evidence of deleveraging. Indeed, China is as addicted to its credit bubble as ever, while Turkish credit growth is inexplicably re-accelerating. The charts below put China’s credit bubble into perspective, where the increase in China’s private debt/GDP ratio since 2008 is bigger than the US’ and the UK’s credit bubbles in the years running up to 2008, and China’s total debt/GDP ratio is approaching Japan’s ratio in 1988. A banking crisis in China at some point looks inevitable. Although a banking crisis will put a dent in China’s GDP growth, it shouldn’t be catastrophic for the economy in light of existing capital controls and high domestic savings (these savings will just be used to plug the holes in banks’ balance sheets). The pain will likely be felt more in China’s key trade partners, particularly in those most reliant on China’s surging and unsustainable investment levels, and of those, particularly the countries with growing external vulnerabilities (see If China’s economy rebalances and growth slows, as it surely must, then who’s screwed? Mar 2013).

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And probably the biggest concern is the rapidly deteriorating current account balances for almost all EM countries, where a country’s current account is essentially a broad measure of its trade balance. If you look through historical financial crises, large and/or sustained current account deficits are a feature that appears time and time again. Current account deficits were a feature of the LatAm debt crisis of the early 1980s, the Exchange Rate Mechanism (ERM) crisis in 1992-3, Mexico in 1994, Asia in 1997, (arguably) Russia in 1998, Argentina and LatAm generally in 1999-02, Eastern Europe and many developed countries in the run up to 2008, and the Eurozone periphery (2010-?). Current account deficits are not by themselves necessarily ‘bad’ since by definition a current account deficit in one country must be balanced by a current account surplus elsewhere, and a country ought to be running a current account deficit and therefore attracting foreign capital if it has a young population and superior investment prospects. Foreign investors will willingly fund a current account deficit if they expect their investment will result in future surpluses, but no country is able to run a current account deficit (which is the same as accumulating foreign debt) indefinitely – if foreigners see a deficit as unsustainable then a currency crisis is likely. Maybe Mongolia’s or Mozambique’s current account deficits of almost 40% last year can be justified by the high expected returns from the huge mining/energy investment in the countries. Or maybe not.

But consistently large deficits, or rapidly deteriorating current account balances, can be indicative that things aren’t quite right, and that’s how many EM countries look to me today. Morgan Stanley coined the catchy term the ‘fragile five‘ to describe the large EM countries with the most obvious external imbalances (Indonesia, South Africa, Brazil, Turkey and India), and this is a term I gather those countries understandably aren’t overly impressed with (BRICS sounded so much nicer…). Unfortunately the list of fragile EM countries runs considerably longer than just these five countries.

The chart below highlights a select bunch of EM countries that are running current account surpluses and deficits. Some countries look OK – the Philippines and Korea appear to be in healthy positions on this measure with stable surpluses. Hungary has moved from running a large deficit to a small surplus, although Hungary needs to run sustained surpluses to make up for the period of very large deficits pre 2009*.

Almost all the other surplus countries have seen fairly spectacular declines in their current account surpluses. Malaysia’s surplus has plummeted from 18% of GDP in Q1 2009 to 4.6% in Q2 2013, while Russia, which is regularly cited as being among the least externally vulnerable EM countries, has seen its current account surplus steadily decline from over 10% in 2006 down to 2.3% in Q2 this year, a number last seen in Q2 1997, a year before it defaulted. Russia’s deteriorating current account is all the more alarming given that the historically high oil price should be resulting in large surpluses. Financing even a small current account deficit (which by definition would need financing from abroad) could cause Russia serious problems, and a lower oil price could also result in grave fiscal stresses given that the breakeven oil price needed to balance Russia’s budget has soared from $50-55/ barrel to about $118/ barrel in the last five years.

Many (but not all) current account deficit countries are looking grimmer still. A number of countries are seeing current account deficits as large or larger than they have historically experienced immediately preceding their previous financial crises. Turkey has long had a very large current account deficit, and while it has improved from almost 10% of GDP in 2011 to 6.6% in Q2 this year, the central bank’s reluctance to hike rates in response to a renewed credit bubble suggests this will again deteriorate. Despite the sharp drop in the rand, South Africa’s economic data has not improved – its current account deficit was 6.5% of GDP, and Q3 is likely to be very weak given the awful trade data in July and August. I continue to think South Africa should be rated junk, as argued in a blog from last year (the modelled 10% drop in the rand actually turned out to be overly optimistic!). India’s chronic twin deficits have been well documented – its current account deteriorated sharply in recent years, hitting a record 5.4% in Q4 2012 and with only a marginal improvement seen since then. As previously highlighted, Indonesia’s current account is now back to where it was in Q2 1997, immediately before the outbreak of the Asian financial crisis. Thailand’s previously large current account surplus has moved into deficit. Latin American countries tend to run reasonable sized deficits (as they generally should, given their stage of development), although Brazil and Chile have moved right into the danger zone.**

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Another concern is contagion risk. If the Fed does tighten monetary policy next year, investors withdraw from EM en masse and capital flows back to the US, and/or China blows up and takes EM down with it, then an EM crisis this time around could look very different to previous ones. EM crises have historically been regional in nature – the international debt crisis of the early 1980s is a possible exception, but even then it was Latin America that bore the brunt. The big difference this time around is that a material portion of the portfolio flows are from dedicated global EM funds and large ‘Total Return’ style global bond strategies, as opposed to flows from banks. If these funds withdraw from EM countries, or to be more precise, if the end investors in these funds liquidate their holdings in the funds, then the funds will be forced sellers of not only the countries that may be in trouble at that point in time, but will also be forced sellers of those countries that aren’t necessarily in trouble. In fact, in a time of crisis, they may only be able to sell down the better quality more liquid positions such as Mexico in order to meet redemptions. So if a crisis does develop then you’ll probably see a correlation of close to one across EM countries. And not just between EM countries – the fate of, say, Ireland, may now be tied to that of Ukraine, Ghana, Mexico, and Malaysia.

That’s the rather lengthy ‘story’ for emerging markets, but what about the most important thing – valuations? In June I concluded that following the sharp sell-off, EM debt offered better value than a few months before, and it therefore made sense to be less bearish on an asset class that we have long argued has been in a bubble (but that didn’t mean I was bullish). As mentioned above, EMD has now recovered roughly half the sharp losses of May and June, but given very little has fundamentally changed over the period, it makes sense to be more concerned about valuations again.

The charts below illustrate the yield spread pick up over US Treasuries on hard currency (as shown by the JPM EMBI Global spread) and EM local currency (as shown by 10 year yields on Brazil, Indonesia and Mexico). Even though a number of EM macroeconomic indicators are at or approaching historical crisis levels, spreads on hard currency EM debt are not far off the tights (although at least you are exposed to the US dollar, whose valuation I like). EM local currency yields are also offering an unspectacular yield pick up over US treasuries, but here you have to contend with a lot of EM currencies with arguably shaky valuations, and you additionally face the risk of some countries being forced to run pro-cyclical monetary policy (i.e. EM central banks hiking rates in the face of weakening domestic demand in order to prevent a disorderly FX sell-off , the result of which sees local currency bond yields rising, as seen recently in Brazil, India, Indonesia).

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So rising EM external vulnerabilities, combined with what are now fairly unattractive valuations, means that EM debt could potentially be teetering over the edge. Would the Fed give EM the final shove though?

On the one hand, while US domestic demand was considerably stronger in the 1990s than today, it’s interesting that during the really bad EM crises in 1997 & 1998, US GDP didn’t wobble at all, not remotely. US GDP was 5% in 1998, the strongest year since 1984, and 1997 saw the US economy grow at a not too shabby 4.4%. The Fed Funds rate didn’t budge at all in 1997 through the Asian crisis, and it wasn’t until after the Russian crisis in September 1998 that the Fed cut interest rates from 5.5% to 5.25% (and then again in October and November down to 4.75%), although this was a combination of domestic and foreign factors. Rates were actually back at 5.5% by November 1999 and continued higher to 6.5% by May 2000.

On the other hand, EM countries now account for about half of global GDP, so a direct hit to EM could loop quickly back to the US. This is something that the Federal Reserve has become acutely aware of in recent months (in case they weren’t already) given the extreme moves in EM asset prices. And in both the June and September press conferences, Bernanke was keen to stress that the Fed has lots of economists whose sole job is to assess the global impact of US monetary policy, and what’s good for the US economy is good for EM. That said, if US growth hits 3% next year, which is possible, it’s tricky to see how the Fed won’t start tightening monetary policy regardless of what EM is up to.

But the deteriorating EM current accounts may mean that at least a few EM countries won’t have to wait for a push from the Fed; they may topple over by themselves. A deteriorating current account deficit means that a country needs to attract ever increasing capital from abroad to fund this deficit. If developed countries’ appeal as investment destinations improves at the same time that a country such as South Africa’s appeal is deteriorating due to deteriorating economic fundamentals or other domestic factors, then investors will begin to question the sustainability of the deficits, resulting in a balance of payments crisis. EM investors need to be compensated for these risks in the form of higher yields, but in the majority of cases, yields do not appear sufficiently high, which therefore makes me more bearish on EM debt valuations.

*A current account deficit is an annual ‘flow’ number; Hungary’s ‘stock’ still looks ugly thanks to years of deficits, as shown by its Net International Investment Position. Hungary’s current account surplus is one of the few things Hungary has going for it. For more see previous blog.

** I’m still slightly baffled as to why Mexico HASN’T had a credit bubble given the huge portfolio inflows, the relative strength of its banking sector and a very steep yield curve, and it remains a favoured EM play (see Mexico – a rare EM country that we love from Feb 2012, although I’d downgrade ‘love’ to ‘like’ now given the massive inflows of the last 18 months and less attractive valuations versus its EM peers).

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EM debt funds hit by record daily outflow – is this a tremor, or is this ‘The Big One’?

On Friday last week, EM debt funds saw a daily outflow of $1.27bn, which equalled the record set during the dark days of September 2011, a time when the Eurozone periphery and the ECB were particularly active bungee jumping down a precipice.   Outflows were even bigger on Monday this week, as EM debt funds were hit by $1.44bn in outflows.  The fact that Monday saw a daily record wasn’t much of a surprise; markets were violent, even by recent standards, with some Turkish bank bonds down 10% intraday at one point.   Outflows were a slightly less bad $1.07bn on Tuesday this week (the most recent data available), but that’s still $3.78bn of EM debt fund outflows in just three days.

The chart below plots the year to date daily flows in US high yield and EM debt, courtesy of EPFR.  Note that this data is for mutual funds only and doesn’t include flows from insurance companies, central banks etc, so while it gives you an idea of how grim the picture looks, it’s perhaps only 10% of the whole picture.  Note also that the EM debt asset class is significantly bigger than it was just two years ago thanks to a huge amount of debt issuance, meaning that although Monday saw a record outflow in absolute terms, it actually ranked number four relative to the size of the market.

EM debt funds hit by record daily outflow on Monday this week

Do the outflows matter?  EM debt bulls might argue no -  fund flows tend to lag market performance and flows have historically had little if any predictive power in forecasting future returns. The collective human instinct is always to buy at the top and sell at the bottom, and the losses in EM assets in the last seven weeks told you the outflows were coming.  Bulls might also argue it is comforting that EM debt outflows haven’t actually been bigger.  EM debt has seen the biggest drawdown since Q4 2008 – in the last 7 weeks the JP Morgan GBI-EM Index, a commonly used EM local currency sovereign debt index, has plummeted  13%, and the JP Morgan EMBI Global diversified index, a widely used EM sovereign external debt benchmark, has fallen over 10%.  Real money investors aren’t yet capitulating, which suggests that the huge inflows of the last few years are relatively sticky.

EM debt bears might look at it another way – in the context of the enormous inflows into EM debt in the last four years in particular, outflows haven’t actually been that huge, and yet returns have been abysmal.  One of the unintended consequences of much tighter bank regulation and balance sheet deleveraging is that market markers have reduced ability to warehouse risk, so relatively small changes in EM debt fund flow dynamics are causing far greater swings in market prices.   If outflows continue at this pace or worsen, then the effect on EM debt will likely be cataclysmic.

Are these outflows just a tremor, or are we witnessing ‘The Big One’?  To begin to attempt to answer that, it’s necessary to figure out what has caused such a violent sell off.  About a year ago I tried to explain that the reasons most people seem to buy EM debt – strong growth, good demographics, low government debt levels, an ‘under-owned asset class’ – are broadly irrelevant.   Thailand and Malaysia had great demographics in the mid 1990s, but that didn’t prevent the Asian financial crisis.  Ireland and Spain had very little government indebtedness prior to 2008, but that didn’t help much either. EM debt returns are instead largely a function of US Treasury yields, the US dollar, and global risk appetite, where the mix varies depending upon whether you’re looking at EM local currency debt, or EM external sovereign or corporate debt (see Emerging market debt is cool but you may be surprised what you find if you strip away the marketing myths for more).

The recent EM debt sell off appears to justify this view of the primary drivers of EM debt returns.  Market commentators’ explanation for the recent leg down in EM debt is Bernanke’s tapering talk, and this is clearly a factor.  Treasury yields have jumped, the US dollar has soared, and EM currencies have mostly slumped.  This is something that we had anticipated and were positioned for as explained in January, see Why we love the US Dollar and worry about EM currencies.

If you assume this EM debt sell off has all been about Fed speak, then I’d actually be much more comfortable about EM debt valuations now. EM bond yields have risen significantly faster than US Treasury yields, while EM currencies have generally fallen sharply, so EM debt valuations are obviously relatively more attractive now versus two months ago.   At the time of writing back in January, 10 year US Treasury yields were 1.8% and we believed they looked ripe for a correction.  Now, however, yields are above 2.5%, and yet the solid but unspectacular trajectory of the US economy hasn’t really changed that much.  Meanwhile US inflation expectations have in fact fallen considerably – for example the US 5 year 5 year forward breakeven inflation rate has slumped from 3% to 2.4%.  Jim discussed the US economy following a research trip in a blog earlier this month, see While the market gets excited about unemployment falling to 6.5%, the Fed’s attention is turning to falling inflation.

However, the recent EM debt move is unlikely to be all about Fed speak.  EM debt has been a stand out underperformer in the great carry sell off of the last two months, and dynamics in Japan and China are surely also important.  I believe that the behaviour of domestic Japanese investors is playing a greatly under-appreciated role.  In the early days and months of the much hyped but so far little-achieving ‘Abenomics’, every man, his dog, and his dog’s unborn puppies seemed to have gone long USD, short JPY, long risky assets and particularly long EM debt.  Some did it in a very leveraged way, and these trades have been a disaster since the beginning of May.  As mentioned in a blog a month ago, Japanese investors have in fact done the precise opposite of what every market participant seemed to think they would do. Below is an updated chart from a blog last month (see Japanese investors are not buying foreign bonds, they’re selling).  Japanese selling of foreign bonds has accelerated further recently, with the announcement overnight that there were ¥1.2 trillion of sales alone during the week to June 21st. Taking a rolling three month average, Japanese investors are selling foreign bonds at a near record pace.

Japanese investors have been selling foreign bonds not buying

It is the China dynamic that I find particularly worrying.  Commentators have focused on the drying up of Chinese inter-bank liquidity as demonstrated by spiking SHIBOR rates, although I think fears are overblown.  There is much speculation as to why SHIBOR has soared, the only additional observation I have is that spikes in SHIBOR are nothing new – I wrote a brief comment about a previous episode in January 2011, see funny goings on in Chinese banking sector.  There was a near replica of the current SHIBOR spike exactly two years ago, and while the SHIBOR moves this time around are particularly big, it’s hard to see why this time it’s different and the PBOC won’t supply liquidity.

A much bigger longer term China worry is that market participants still believe that China can grow at 7%+ ad infinitum, but I can’t see any scenario under which this is actually possible.  China’s wages have doubled since 2007 and its currency has appreciated 25% against the euro and 35% against the US dollar (based on spot return) since China dropped its peg in 2005.  Competitiveness has therefore significantly weakened.  Intentionally or unintentionally, the Chinese authorities have tried to hit an unsustainable growth target by generating one of the biggest credit bubbles that the world has ever seen.   If you add that an enormous demographic time bomb is starting to go off in China (eg see article from The Economist here), China’s long term sustainable growth must be considerably lower than consensus expectations.  Some believe the Renminbi’s destiny is to become a currency to rival the US dollar.  I think it’s more likely that opening up the capital account will encourage big capital outflows as domestic investors seek superior investment returns abroad (as an aside,  Diaz-Alejandro’s paper Goodbye Financial Repression, Hello Financial Crash offers some background on Latin America’s experience with financial liberalisation in the 1970s and 1980s).

My central thesis remains, therefore, that China will experience a significant slowdown in the coming months and years and this will have profound effects for global financial markets and EM debt in particular.  If you like clichés, China is in effect ‘turning Japanese’, but unlike Japan, it has grown old before it has grown rich. Rather than regurgitate the arguments, see blog from March (If china’s economy rebalances and growth slows, as it surely must, then who’s screwed?).  I continue to believe that EM and developed countries with a heavy reliance on exporting commodities to China are vulnerable, countries that are increasingly reliant on portfolio inflows from developed countries to fund their current account deficits are vulnerable, and those countries that tick both boxes (eg Australia, South Africa, Indonesia, Chile, Brazil) are acutely vulnerable.

In sum, EM debt now offers relatively better value than a few months ago, and it therefore makes sense to be less bearish on an asset class that we have long argued has been in a bubble.  That doesn’t mean I’m bullish.   The arguments put forward in September 2011 (see The new big short -  EM debt, not so safe) are more valid now than ever.  Foreign ownership of many EM countries’ bond markets has climbed higher (see chart below), and the EM debt outflows of the past few weeks are a pimple on an elephant’s derriere in relation to the decade-long inflows.  These inflows were initially driven by US investors fleeing the steadily depreciating US dollar, and more recently driven by European investors looking to park money outside the Eurozone.   Following the recent sell off, the vast majority of investors who have piled into EM debt in the last three years are underwater, and it will be interesting to see how they react.

Foreign ownership has increased enormously

The recent EM debt sell off probably isn’t yet ‘The Big One’, it is more a tremor.  ‘The Big One’ will probably need either US growth and inflation surprising considerably to the upside or China surprising to the downside.  If that happens then EM debt could really rumble, and these eventualities still don’t seem to be remotely priced in. It will take a much bigger sell off in EM debt, and specifically much higher real bond yields, before I’d turn outright bullish on EM debt and EM currencies.  Developed markets and specifically US dollar assets appear more likely to appreciate, and it’s ominous that previous periods of US dollar strength (1978-1985, 1995-2002) have been coupled with EM crises.

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Asian currency wars; is China really the ‘currency manipulator’?

Ever since the Asian financial crisis in 1997, Asian economies have generally engaged in a policy of maintaining artificially cheap currencies in order to generate export-led growth. This led to substantial political pressure being placed on Asian countries, primarily from the US, to allow their currencies to appreciate.

The problem facing export dependent Asia is that this growth model has now broken. Firstly many of Asia’s currencies no longer appear that cheap (eg Indonesia is running its largest current account deficit since Q1 1997 and its reserves hit a two year low last month), and secondly, who is going to import all the exports given that the developed world is busy deleveraging?

These export dependent countries have been left fighting over a shrinking pie, or at least a non-growing pie. When countries are dependent on exporting tradeable goods, small changes in currency valuation can make a big difference to competitiveness. (As the UK has discovered, the flip side is that devaluation doesn’t make the blindest bit of difference when selling tradeable goods forms a very minor part of your economy.)

And that’s when you get currency wars. In the note I wrote in January (see why we love the US Dollar and worry about EM currencies), I mentioned that China’s devaluation in 1994 is widely cited as being one of the triggers for the 1997 Asian financial crisis. If you consider that Japan is currently more important to many Asian countries’ trade today than China was in 1993, could a big yen devaluation wreak havoc on the region in the same way?

The chart below shows the magnitude of Japan’s so far successful devaluation versus China, its biggest trade partner and global competitor. Some Asian currencies have weakened a little in sympathy, but more from investor expectations of action rather than from action itself. Chinese exports grew at a surprisingly strong 21.8% year on year in February, but it will be very interesting to see whether this can be sustained, whether other Asian countries can bounce from their current export slump, and if not, then what the region’s central banks and governments plan to do about it.

CNYJPY spot exchange rate

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Europe, China and shale gas: euphoria or rejection?

It is commonly believed that – thanks to shale oil and gas discoveries in the US over the past couple of decades – the US is on a path towards energy self-sufficiency.  Subsequent cheaper gas prices are boosting competitiveness in some domestic industries, starting from bulk chemicals and primary metals, by lowering the costs of both raw materials and energy.

Gas production in the US

Gas prices: a diverging trend

But will the US and its domestic companies be forever the only beneficiaries of cheap gas, as many believe?  In Davos in January 2013, Royal Dutch Shell PLC signed a 50-year profit sharing deal with Ukraine to explore and drill for shale gas and oil.  In fact, shale formations are not a prerogative of the US.  Several countries in Europe and Africa have significant shale gas reserves (France, UK, Poland, Germany, Turkey, Ukraine, South Africa, Morocco, Libya, Algeria), and some other countries around the world too (Chile, Canada, Mexico, China, Australia, Argentina and Brazil).  Preliminary research has shown that there are 32 countries with more than six times the amount of technically recoverable shale gas than the US. It will be key to understand which ones will prove of high “quality”: in fact US shale basins tend to have rocks closer to the surface (easier to reach) and more porous (where gas is easier to extract), while foreign reserves tend to be deep and harder to reach (therefore more technically challenging and expensive).

Currently in Europe the shale gas debate is divided between euphoria and total rejection.  A drilling procedure called “fracking” sees a cocktail of water, sand and some chemicals pumped into a well under high pressure to force the gas from the rocks.  Early drillings in Netherlands and Luxembourg were suspended because of environmental fears and contrarian public opinion.  In France, fracking is now banned, while in Germany opposition to Angela Merkel is creating a good deal of noise around this topic.  In Poland, ExxonMobil just walked away from preliminary explorations that didn’t deliver the expected results and, in Spain, the Basque local government has announced that there is 185 billion cubic meters of shale gas in the Gran Enara field with €40m invested in exploration.

No rapid breakthroughs are expected though.  Exploiting shale gas reserves in Europe might be a long, technically difficult, politically tricky and also legally complex procedure, due to questions over property rights – determining who can drill and where.  But the need to look for security of supply and cheaper energy sources remains. In particular, as Orlando Finzi – our M&G credit research director covering the energy sector – was telling me the other day, the latter is the subject of a key debate at the moment: EU long term gas contracts which supply most of the gas to Europe have prices linked to oil, but this might all change with recent negotiations between buyers and sellers seeing a modest dilution of the oil linkage.  RWE, the German utility, is seeking full removal of oil price linkage in its Gazprom contract via arbitration courts.  Where will European prices head to then?  If lower, the idea of extracting shale gas may become less attractive than the existing natural gas options.  If prices continue to rise, who knows?  Also, the need to reduce CO2 emissions may push towards unexplored scenarios.  Some think that the current CO2 emissions “cap and trade” system is disappointing (see the chart below): too many permits in the market and therefore no incentives to cut emissions.

The CO2 trading system in Europe

Gas is a great alternative to other fossil fuels (and coal specifically, but also oil) to both cut down emissions and potentially to cover when renewables do not generate (for example, wind turbines in a period of no wind).  Will European countries, eventually strangled by economic stagnation, fearful of security of supply and in need to cut emissions, find a way to overcome multiple issues to give a boost to shale gas exploration?  In a positive political climate, what if UK and Spain will be quick and successful in exploiting their shale gas resources?  Will this new energy source support growth, help employment in weak economies and make local companies more competitive in certain industries?

More euphoria is engulfing China.  China’s revolution in shale gas is considered by some more a distant dream than a work-in-progress, but there are many new developments worth considering.  Chinese public opinion has recently been shaken by the terrible air quality in many cities.  China, estimated to have the biggest reserves in the world (50% more than the US as per an early research by EIA) is explicitly moving towards cleaner energy sources and has an incredible appetite for energy (and gas specifically, now fully imported).  Even if little information exists, Petrochina, which is currently undertaking the development of shale gas in Alberta via a partnership with a Canadian company, has started shale gas drillings around China.  Total is also preparing to sign an agreement, possibly within a few days, with a Chinese partner to explore for shale gas in the country.  Furthermore, China just announced that 16 (only domestic) companies won a second round of bidding to explore 19 shale gas blocks around central China, agreeing to invest $2 bn over the coming years.  The key issue also in China – and in some other countries such as Argentina and Mexico – will be to understand which technology to use and how to unlock reserves that are very difficult and expensive to reach for geological reasons:  I would expect quicker progress only with foreign technology. But local energy needs, resolute politics and a more benign public opinion – now suffocated by smog – make the Chinese case stronger than Europe.  If shale reserves are exploited quicker than expected, will China return to the good old days of double digit GDP growth?  Will Chinese companies – which are losing their cost leadership position to neighbouring countries such as Vietnam and Indonesia or back to the US – find in local shale gas a new source of sustainable competitive advantage in the next ten years?  Will the predicted shift of production and employment back to the US be a temporary adjustment only?

Reading the future of energy remains very complex.  The prospects of shale gas developments outside North America will depend to a large extent on politics and developments in international gas markets, such as the future relationship between demand and supply, price relations (Liquified Natural Gas vs. pipelines for example) and movements, costs of production, shape of climate policies (it’s difficult to see how other countries such as Argentina, for example, will be able to persuade foreign companies to help it develop its reserves while it has been busy expropriating assets) and specific local challenges.  But imagine a not-so-remote scenario at this point: US shale gas may return less than expected over the long term (as the EIA always reports, the long-term production profiles of US shale wells and their estimated ultimate recovery of oil and natural gas are uncertain), while China and Europe may start exploiting shale reserves quicker, thus reshaping energy pricing dynamics or even the balance of world trade and geopolitics.

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