Remember the ‘fragile five’? These were five emerging market currencies that were deemed to be most at risk of US policy tightening during the ‘taper tantrum’ of 2013. The main concerns for these economies centred on their vulnerability to foreign capital outflows.
Recently we’ve seen a re-emergence of these types of fears, sparked by recent US Dollar strength against most major currencies globally.
Some of the original five are less fragile than they were, but there are very real pressures being felt in parts of the emerging world, especially in Turkey (figure 1) and Argentina (figure 2).
And yet, the external vulnerabilities in these economies that seem to be driving markets today have been present for many years, while US short rates have been increasing since 2015. Why is it that investors seem to pay attention to these risks in some phases and not in others? Why did the recent problems in Argentina (as discussed by Claudia two weeks ago) seem to take investors by surprise?
It might be tempting to dismiss this market behaviour as just another example of laziness, greed, and complacency (here is what we said about Argentinian US Dollar Bonds in 2016), but this would be over simplistic. Behavioural influences do play a role, but so do the genuine characteristics of these types of risk. Investors need to be clear which is dominant if they are to identify opportunities.
Turkey and Argentina: fundamentals matter over longer time horizons…
Perhaps the main standout from the chart of the fragile five currencies above is the far greater weakness in the Turkish Lira than in the other four. This is understandable, since fundamentals in Turkey have deteriorated since 2013, whereas the others have improved.
We can see this in the evolution in the current account position. Often it is far too simplistic to look at deficits alone as a measure of vulnerability (they can be perfectly benign in some conditions) but in this instance the story they tell is valid (figure 3).
By adding Argentina to the mix, we can also begin to see how the recent problems there have emerged.
In this sense there is nothing behavioural about what markets are doing. From an economic standpoint adjustment via the currency is needed to correct imbalances, while for investors there is a genuine increase in risk which should require additional compensation. The ultimate destination of a currency will usually be consistent with the evolution of underlying fundamentals.
…but risks are conditional and binary
However, there is an additional challenge for investors in thinking about these external vulnerabilities: risks are conditional, and can have very binary characteristics.
Conditional in the sense that, in asset pricing at least, sometimes current accounts matter, and sometimes they don’t. For example, when we look at recent periods of emerging market currency weakness, current accounts have ‘mattered’ at inflection points for US rates and the DXY Dollar Index (illustrative of broad-based Dollar strength), but not in other phases.
Even worse, when they do matter, the outcomes can be very bad indeed (hence ‘binary’). Balance of payments crises can display similar dynamics to bank runs: they are driven by the mood of investors, they can become self-fulfilling, and they can be ruinous.
It is possible to build quantitative assessments of how vulnerable a country is to capital outflows using a range of metrics, but obsessive focus on incremental changes in these can mean missing the wood for the trees. Like bank runs, balance of payments crises (as opposed to straightforward inability to pay Dollar liabilities) are largely unpredictable as to their timing, and some never happen at all.
The human element
Such dynamics are a challenge for investors and can be a major source of emotional stress (Nassim Nicholas Taleb’s work frequently observes that the investment industry is poor at conceptualising low probability, high impact events). Do we refuse to play, because there is a genuine risk of complete ruin (‘precautionary principle’)? Or do we simply ignore the tail risks and hope that risk premia and diversification will mean that we win over the long run?
Some will take either of these extreme positions, but aggregate market behaviour often becomes a halfway house, oscillating between apparent complacency and signs of panic. And it is the human element behind these shifts that can create investment opportunities.
Recent work in the field of behavioural finance/economics by Xavier Gabaix provides a good framework for thinking about this issue. His theory of behavioural inattention considers how human beings respond to new information.
We are presented with countless pieces of information every day, and we have to apply a filter to decide which of this information is ‘signal’ (and relevant to the decisions we have to make) and which is ‘noise,’ and then decide how much attention to pay to each.
Gabaix observes that this filtering process is largely unconscious, and as a result is where behavioural biases become evident. When we are under time pressure, when it takes a lot of effort to interpret a signal, or when a variable becomes alarming, we will pay different levels of attention. As an example, we may downplay Argentinian current account and currency reserve data as an influence of our investment decisions in normal times, but when the Argentine Central Bank increases interest rates three times in eight days, these factors are suddenly given far greater weight, perhaps at the expense of other forces.
Looking for opportunities and the current state of play
It is in the human behavioural dynamics of shifting attentions investment opportunities are created.
Are investors today overly concerned about the vulnerability of emerging markets? One way of assessing this might be to look at the nature of price action. As an example, Turkish Lira weakness for much of the last five years was of a gradual nature, suggesting investment decisions weren’t being made under stress. By contrast, more recent weakness looks somewhat ‘episodic’ in nature, as does the nature of recent commentary.
Against this we must weigh the ability for value to act as a long term ‘anchor’ on price behaviour and as a predictor of returns. In the case of currencies, ‘pricing model uncertainty’ is high, spot rates can overshoot to extreme degrees and any sense of ‘fair value’ is weaker than in other assets. Together with the binary nature of balance of payments risks, this suggests that it is appropriate to look for more extreme signals than might be the case in other assets before investing.
Another sign that behavioural forces are driving prices would be contagion. If all emerging market currencies were being hit to the same extent it may suggest that panic is causing indiscriminate selling and shorter time horizons in investors. This has not been the case so far this year, though there have been signs of contagion more recently. Markets have been relatively discerning; those currencies that have depreciated have tended to be those with the largest fundamental challenges.
At present therefore it seems that, if opportunities are being created, they could well be in ‘the eye of the storm’ and a question of whether Turkish and Argentinian moves are overdone.
Ultimately, there will always be good arguments on either side as to whether opportunities are being created, either in specific countries or more broadly across emerging markets. However, one rule of thumb is generally useful: we should be worrying most when the market is paying least attention and should be looking for opportunities when the market is most worried. Right now, we can’t deny that emerging markets have got most people’s attention.