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July 2018

Understanding EM
Contents Turkey today is a live-action example of an EM crisis in full-swing. It has been our
top candidate for a currency crisis since 2014. Years of repressed interest rates have
2 Stock market and currency
swings during economic crises
led to rampant, double-digit inflation that erodes confidence and therefore growth.
3 New capital inflows signal Foreign capital grows impatient and starts to leave, looking for higher, more stable
recovery returns. With US rates yielding over 3%, these are not difficult to find. Capital fleeing
6 No one-size-fits-all strategy
a country so heavily dependent on foreign capital - Turkey’s current account deficit is
almost 6% of GDP - is salt in the wound for growth, and the situation worsens. But
how does one navigate and understand EM crises like Turkey’s?

In this report, we’ll look at the history of EM crises. How they unfold, and when
they become buying opportunities. EM crises have generated some of the largest
market sell-offs in the last 25 years. At the same time, the stock-market bottoms and
currency devaluations that follow financial crises can make them smart contrarian
buying opportunities. In this report, we present a condensed analysis of countries’
financial recoveries from economic crisis, with an eye towards spotting post-crisis
buying opportunities.

The question of when exactly to buy following a crisis, like Turkey’s, is paramount: buy
too early and markets may plummet further; buy too long after a crisis has abated,
and most price appreciation will have already occurred, limiting the potential upside.
There is no one-size-fits-all strategy for taking profit on the heels of financial crises,
and identifying post-crisis buying opportunities is challenging. At the same time, our
research indicates predictable patterns in how economies recover from economic
crises across countries and over time.



In trying to establish where opportunities are created in crises, we have measured the size of
the drawdowns heading into market bottoms for equities and currencies, as well as the size
of the rebound in the three months coming out the other side.

Stock Market Crises 1988 - 2009 Currency Crises 1988 - 2009

150% 130% 60% 50%
109% 44%
97% 39%
100% 88% 87% 40% 29%
72% 64% 22% 19%
44% 20% 11% 10% 8%
50% 33% 6% 4%
10% 0%
0% -4% -3%
-50% -22% -31% -33%
-24% -25%
-41% -40%
-50% -54% -38% -36%
-100% -75% -79% -72%
-60% -54% -54%

3m USD Decline in Equities 3m Post-Crisis USD Rally in Equities 3m Decline into Currency Bottom 3m Rally out of Currency Bottom

Above we can see that in the case of both equities and currencies, there is a wide variation
in the magnitude of the decline prior to, and the recovery from a bottom. Typically, a greater
drawdown leads to a stronger recovery, and equities bounce back stronger than currencies
do. As one might expect, more developed economies are less sensitive in these situations,
with Finland, Norway and Sweden ranking among the least volatile in both equities and

Where crises are regional, i.e. negative contagion has spread the problem from one country
to its neighbours, we often see markets bottoming around the same time, and recover to
similar degrees. Positive contagion during the recovery is as much a factor as negative
contagion is during the crisis.

During crises, signal-based trading methods become ineffective, as the market moves are
so large that traditional technical measures are less informative. Below we have charted the
returns of two buy and hold strategies in currencies and equities: one is a two-year holding
period beginning three months after the date of devaluation, and the other is a one-year
holding period beginning eighteen months after devaluation.

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Charts Source: Bloomberg, Macrobond and Variant Perception

Total 2-Year Return: Buy & Hold Currencies 3m after Total 1-Year Return: Buy & Hold Currencies 18m after
Devaluation Devaluation
60% 51% 25% 22%
40% 20%
12% 14%
20% 15%
0% 10% 8% 7%
-20% -9% -11% 5%
-16% 0%
-40% 0%
-60% -5% -3%
-58% -5% -6% -6%
-80% -10%

As we can see above, currency returns are unreliable under any strategy. Generally, equity
returns are positive under both strategies, however neither emerges as a ‘better’ solution
across all markets. There is no one-size-fits-all buy strategy, so we must look at
underlying economic indicators to find buying opportunities. Typically, equities appear to
offer far greater reward for the risk attached than currencies.

Total 2-Year Return: Buy & Hold Stocks 3m after Total 1-Year Return: Buy & Hold Stocks 18m after
Devaluation Devaluation
400% 70% 60%
336% 60%
300% 39%
40% 33% 33%
250% 209%
184% 30% 21%
15% 15%
135% 20%
150% 113%
10% 3%
100% 56%
38% 0%
50% 9% 1% -10% -2%
0% -20%
-50% -28% -30% -21%


Through studying numerous crises, we have identified what we believe to be the key to
recovery. Upturns in monetary and liquidity indicators suggest renewed confidence, and
when capital inflows return, we can be confident that the economic outlook has turned.
Emerging market crises have largely followed a similar, four-stage pattern over the last few

1. A shock - consumer loan defaults in Thailand in 1997, or a surprise devlauation of the

peso in Mexico in 1994 - causes a panic-fuelled capital flight. Michael Pettis has referred to
this rapid liquidity contraction as “a short-term collapse in financing at the margin”, leading to
a significant decline in the value of the currency.

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Charts Source: Bloomberg, Macrobond and Variant Perception

2. The central bank will try to support the tumbling currency by selling its foreign exchange
reserves. Very rarely are these efforts viewed as credible, however, so the central bank falls
back on interest rate hikes as its final mechanism to protect the currency. These rate hikes
are often sizeable given the extreme situation, and this hits equity markets hard.

3. This situation - a depreciating currency, depleted FX reserves and high interest rates -
causes numerous problems. Emerging markets tend to have what are known as “inverted
balance sheets”, meaning assets are valued in local currency, but a large proportion of
their liabilities are dollar-denominated. The value of the dollar debt jumps as the currency
depreciates. High domestic interest rates make it more difficult to pay off internal
debt. Inflating the debt away is often the most attractive solution here, however this
disincentivises investment.

4. At some point, the central bank is likely to give up defending its currency, meaning it
stops bleeding FX reserves and has the freedom to lower interest rates again. The easier
monetary policy stimulates domestic investment, facilitates debt service, and restores
confidence in the government, all of which attract foreign capital to return to the market.

Having identified that capital flows are key to equity market recoveries, we have examined
trends in FX reserves, the money supply, and level of excess liquidity around these crises.

As we can see below, equity market recovery and the renewed accumulation of FX reserves
are roughly coincident at the ends of these crises. Both Mexico’s and Argentina’s FX reserves
declined dramatically during the crisis, and turned up once their respective central banks
gave up defending their currencies, around the same times their equity markets bottomed.

 

 
  
   
  
  
  
 
 
 
 
 
              

   

Growth in M1 typically tells us that a crisis is in its latter stages. While every crisis is unique,
we have seen a pattern whereby the contraction in M1 reaches around 10% a year before
reversing. This is clearly the case below, in Malaysia and Korea.

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Charts Source: Bloomberg, Macrobond and Variant Perception

 

 
 
 
 
 
 
 
 
 

 
   

            

   

We define excess liquidity as real money growth less industrial production. Increasing
excess liquidity is supportive to asset prices, particularly in smaller emerging markets. It is
no surprise, therefore, that excess liqudity growh in Korea following the Asia crisis had such
a strong effect on equity performance. Excess liquidity growth in Russia, a larger market, is
less closely linked to equity performance, but the bottom in excess liquidity signals an equity
recovery nonetheless.

 

 
 
 
 
 
 

 
  

          

   

In addition, we highlight that rate cuts in crisis countries kickstart revivals in equity markets.
Below we can see that the peak in interest rate leads the upturn in equities. From our
research, a sharper rate cut leads to a more dramatic equity recovery.

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Charts Source: Bloomberg, Macrobond and Variant Perception

 

 
  
 
 
  
 
 
 
             

   

When rate cuts are implemented and equities do finally bottom out, valuations are generally
cheap on a number of widely used measures. While price-to-earnings ratios can be
subjective and therefore the number is not always significant, a price-to-book value of far
less than one is worth paying attention to - particularly when entire indices are valued at
that level. Below we can see that price-to-book ratios on the Mexican index in 1995 and the
Malaysia index in 1998 fell towards 0.5x.

 

 

 
 
 
   
 
 
 
   
 
 
 
   

     

   

When assets are selling for far less than their book values across an entire index, it is
likely the product of contagion, and there will be numerous buying opportunities.


There is no one-size-fits-all strategy for capitalising on the opportunities created by emerging

market crises. The precise causes and timelines differ greatly, but the pattern remains the
same. We must be alert when the currency has been beaten up, interest rates have risen
dramatically, and the central bank has given up defending its currency. Watch for improving
measures of liquidity, rebounds in foreign exchange reserves, and interest rate cuts.

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Charts Source: Bloomberg, Macrobond and Variant Perception

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