Emerging Markets Contagion: Crisis Of Confidence 101

by: Claudio Brocado


I pay attention to history, and know it’s dangerous to think this time is different, but the current emerging markets crisis is.

Fewer reasons to fear meaningful lasting contagion beyond vulnerable emerging markets.

Even in the most affected emerging markets, current levels probably present key long-term contrarian entry points.

Greece, as bad as its situation still is, would be in far worse shape were it not for it having stayed in the euro.

History does not repeat itself, but it rhymes. With my decades of experience following emerging markets, believe me, I'm not one to ignore history or who does not understand the folly of saying “this time is different.” Yet, I do believe it's important to focus on the differences between now and previous crises of confidence to see if Argentina, and even Turkey, may be presenting tremendous long-term contrarian buying opportunities.

Perhaps more important for most investors is whether they should be seriously worried about the current episode of contagion imperiling most of their developed market investments.

What we’re seeing now, in my view, is a typical case of crisis of confidence. The countries feeling the most pain are those with meaningful foreign-denominated debt exposure. The shorter the term structure, the more severe the justified market worries. In the case of Turkey, relatively more recent policy blunders, including administration jawboning of the central bank, have made the situation worse.

As for Argentina, it was the previous administrations that strayed way into unorthodoxy, but the long history of sharp policy swings (and fears that the current administration’s loss of credibility due to the currency overshoot may cause the pendulum to swing back to a less orthodox government next time around) are the key domestic culprits.

In any case, there's a growing crisis of confidence afflicting emerging markets, and policy makers are being put to a severe test. Recent crises of confidence in developed markets include the global financial crisis and the subsequent Eurozone crisis that took the ECB’s Mario Draghi “whatever it takes speech” to finally stem.

The Argentine central bank has shown strong determination to try to regain confidence. Contrary to Turkey, Argentina has enlisted the help of the IMF. Think what you may of that multilateral organization, but its getting involved has helped stem previous crises of confidence across emerging markets.

In 1995, it took the US lending credibility to its then new NAFTA partner Mexico to regain market confidence. It's hard to break the vicious cycles part and parcel of severe confidence crises. Argentina is doing what it can, and I believe that aggressive contrarian investors who buy at these levels will be rewarded in the long run.

Again, more importantly for most investors, I do think this crisis of confidence presents key differences relative to previous episodes. The globe remains awash with liquidity, and the Fed (despite the many interest rate hikes) is still only removing excess monetary accommodation, not tightening yet. Contrary to prior episodes where more widespread contagion took place, a larger number of emerging markets than before are better positioned to withstand the ongoing crisis.

Unfortunately, there will be developed market securities that are somewhat deservedly in the eye of the hurricane. One of them happens to be among my 2018 top picks. BBVA (NYSE:BBVA) has meaningful exposure to both Turkey and Argentina. Part of the reason I included the stock in my list was precisely its emerging market exposure. I have been clearly wrong in expecting emerging markets to have a solid 2018.

Still, for the long term (where I always place my focus), emerging markets are as attractive as ever. Diversification entails that when one asset class suffers, there's another one that makes up for the pain. Emerging markets add diversification benefits to a global portfolio, yet they should never account for a sizable portion of it. The core global developed equities in a long-term portfolio should remain largely insulated from the current EM crisis of confidence.

Finally, a key difference between the current contagion episode and those of 1994/5 and 1997/8 (when many emerging market currencies were pegged at artificially strong levels versus developed market currencies), "developed" countries such as Spain, Italy and Greece then provided meaningful conduits for the EM pain to spread throughout global markets.

I personally cannot believe there's still any serious discussion as to whether Greece should have "grexited" and resurrected the drachma or whether Italy might be better off exiting the euro and going back to the lira. In previous emerging market crises the Spanish peseta, the Italian lira and the Greek drachma plunged along with the Mexican peso and the Thai baht.

I remain absolutely convinced (as Greece recently exited its European bailout program) that, as bad as their situation still is, the Greeks did not have any "good" options. They had to choose the least bad of terrible options, and they made the only viable "right" choice. As I expected to be the case base on theory, the Greek economy achieved a real internal devaluation even as it retained the euro as its currency.

I believe Greece would not only be still economically vulnerable. In my opinion, the Mediterranean country would be in desperate trouble (and perhaps even in a humanitarian crisis not unlike Venezuela’s) had it chosen or been pushed to go back to a drachma that would have plunged in value causing massive debt defaults and an endless cycle of devaluations and hyperinflation. So you see, there's reason to think (despite some analogies to the EM crises of the 1990s) that this time, it is different.

Disclosure: I am/we are long BBVA.