Funds have been flowing out of emerging markets for months now – since the middle of last year in fact, when it became evident that developed markets were healing and the emerging markets might be slowing.
These capital outflows – investors pulling money out of emerging markets like Turkey, Argentina and some of our south-east Asian neighbours – are reversals of the very large inflows that we saw in the dark days of the GFC as as investors allocated capital into what they considered safe ports in the storm stemming from the US sub-prime crisis.
Assets du jour were the stocks and bonds of emerging and associated markets – including Australia – that were seen as being insulated from the developed market rout. So money flowed out of developed stocks and bonds and into emerging markets as the big cuts in Fed, ECB and BoE interest rates drove investors to seek better returns elsewhere.
The result was heavy buying of hitherto semi-illiquid emerging markets currencies driving them to strength unseen, and unwanted in the previous decades. Indeed Brazilian Finance Minister Guido Mantega to declare that there was a currency war raging as far back as September 2010.
Ultimately the Brazilian Real made a high against the US dollar in July 2011 of 1.5509. But other safe harbour markets like Australia also saw their currencies come under upward pressure, to strengthen, arising from inbound capital flows and the Aussie dollar made a high in July 2011 of 1.1080.
Both the Real and the Aussie dollar have since weakened materially as have a number of emerging market currencies such as the Turkish Lira, the South African Rand, Indian Rupee, Indonesian Rupiah and the Russian Rouble to name just a few.
The important thing in the context of where we are today is that this emerging and safe harbour currency strength was a result of billions and billions, likely trillions, of dollars being placed into markets which were simply not well placed in terms of liquidity to cope with the outflows if they were to come in a short period of time.
This rotation of funds out of emerging markets and the Aussie dollar – which the ANZ Strategy team calls Reversification – appears to have hit a tipping point which has precipitated rate rises in defence of their currencies by the central banks of India, Turkey and South Africa in the past few days.
Just last week, after the Peso fell 18%, the Argentinian government reiterated their commitment to capital controls which restrict the purchase of US dollar to less than $2000 per month.
The bad news however is that things could get much worse if the problems spread into developed markets in such a manner as to turn the recent fairly small falls in stock markets into something much worse.
The reason is not economic. It’s not even really market-based. It’s based in our human DNA and the fact that when individuals congregate into crowds or markets they can sometimes act very differently and much less rationally than would otherwise be the case.
The two scholars who give us the best guide to where the markets MIGHT be headed are Hyman Minsky and Benoit Mandlebrot. What they respectively hypothesised, and the GFC proved true, was that periods of low volatility transition to periods of high volatility. And then when volatility spikes it becomes sticky and clusters at these high levels.
As a reminder of what complacency can set in before a crisis, think back to Fed Chairman Ben Bernanke’s 2004 speech titled “The Great Moderation” when academics and central bankers thought that they had washed volatility out of the business cycle. Or, who remembers Goldman Sachs CFO David Viniar in 2007 – before the GFC really kicked off – saying “We were seeing things that were 25-standard deviation moves, several days in a row.” Statisitcally that should never happen in our life time.
As the GFC proved and the chart above of the S&P 500 volatility index versus the index shows low volatility transitions to high volatility and then it clusters.
In that case, Minsky and Mandlebrot were right.
The risk now is that the weakness in US stocks starts to feed on itself as investors, aware that the market has not pulled back materially for more than a year, start to position for such an event, causing a further sell-off.
It implies that in the absence of a circuit-breaker, current market concern about volatility and further weakness could turn into something more dangerous.