“You never give me your money, You only give me your funny paper, And in the middle of negotiations, you break down.” – The Beatles, Abbey Road album, 1969
What CNN called the “British Invasion” of rock music immediately preceded the demise of the Bretton Woods fixed currency exchange rate regime (1945-1971). That era was brought to a close by a global run on gold, President Nixon’s devaluation of the US dollar, and closure of the gold window. The Beatles split up in 1970; the Bretton Woods agreement collapsed in 1971.
Since the old regime came unanchored, the world has operated with floating currencies. Any particular currency has an ever-changing value relative to others unless the government that issues it tries to peg it to another or tries to manipulate the exchange rate. This new global monetary system has been analyzed in serious work by a number of skilled economists. One of them, Mike Dooley, is a fishing regular with us in Maine. Mike has nicknamed the current regime “Bretton Woods II” (Michael P. Dooley, David Folkerts-Landau, Peter Garber; September, 2003; "An Essay on the Revived Bretton Woods System"). Readers should note that this paper was written BEFORE the global financial crisis exploded in 2007-9. Form your own opinions about whether this paper was too optimistic at the time of its publication. What is critical for me is the depth at which it explains the relationships that we see as part of the present-day turmoil.
In our view, the present system is as vulnerable to contagion as the old one was – where contagion is defined as the spreading of financial turmoil due to fluctuating foreign-exchange rates and the unintended consequences of governments trying to intervene in the currency adjustment process. In the last few weeks we have written about contagion and discussed it publicly. Bloomberg, Fox Business, Reuters, the Wall St. Journal, and others have shown interest in our focus on this topic. We expect the global volatility associated with the current turmoil in emerging markets to intensify this discussion of contagion as markets drive investors to change their allocations in response.
We thank readers for their questions about our views on contagion risk. We will try to answer the most important questions raised by clients, their consulting professionals, website readers, and others. Hence, the remainder of this commentary will have a FAQ (frequently asked questions) format.
Q-1. Are you really seriously concerned about contagion?
Yes, indeed. We would not be analyzing it, writing and talking about it, and making portfolio changes if we didn't think it was a serious risk. This writer fails to understand why so many investors and other market agents remain sanguine about contagion risk. Perhaps they are younger and do not remember the demise of the Bretton Woods era. But most should remember 1994 or 1997. And they were certainly around during the last five years, when they witnessed a contagion in a currency zone (the Eurozone). They saw how things started in Greece and what happened after the first elements of failed government policy became apparent to markets. Later, they saw Cyprus’s banking system collapse. And they have witnessed the outcome of policy failures in the largest currency zone in the world (that of the US dollar). All contagions start in a small, seemingly isolated way. Originally they appear minor and readily containable, whether they are triggered by Greek debt excesses, improvident US housing mortgages, Thai civil unrest, or Turkey’s latest interest rate hike.
Financial contagion poses a serious risk. Like a virus, the risk is there all the time, poised to flourish when the financial “immune system” is weak. In periods of stability and strength, steady economic growth, and excess liquidity, that risk is suppressed and masked by other forces. That does not mean the risk has vanished. Then along comes a unique and perhaps unexpected sequence of events that may at first appear to be disparate and unrelated. But that would actually only be the case if all economic entities operated as closed systems, did not trade with each other, and did not have interdependent financial flows – if they were isolated islands. In an interconnected, interdependent world like ours, contagion risk exists at all times. It surfaces here and there, and most of the time it quickly dies back; but given the right conditions it can spread like wildfire. And the degree of spreading and the damage done are always unknown until after the fact.
Q-2. Do rising interest rates matter for emerging markets?
Absolutely, yes. A serious study by Ned Davis Research examined the relationships among interest rates in emerging-market and major economies. That January 30, 2014, study compared US interest rates with those of other countries. It computed the correlations among rising rates and market effects and determined whether these correlations were reliable or useless. The study's conclusion is clear: “Investors can view interest rates as a threat to emerging markets in some environments, an encouraging sign of economic growth in others, and useless noise” in still other instances. Ned Davis asserts that, statistically, rising US interest rates tend to trigger negative impacts in emerging countries like Indonesia and Turkey. On the other hand, rising US interest rates can sometimes have positive effects, as in China.
Q-3. Why do changes in interest rates in one place have impacts elsewhere?
The impacts depend on the composition of the financial relationships and trade flows of goods and services. That leads to the question of why certain markets respond to forms of contagion differently from others. The Ned Davis study lists all major emerging-market countries and breaks them into categories of interest-rate sensitivity, useless noise, and insulation or beneficial impacts from interest sensitivity. At Cumberland, we use services like Ned Davis and also our own internal work to develop a nuanced awareness of these sensitivities and responses as we continually evaluate over 40 countries.
Q-4. What is going on in the world today, anyway?
We see interest rates being used by central banks and governments to defend currencies or to alter the composition of flows in their economies. Turkey may be the most obvious example today, but we see similar activity in South Africa, India, and elsewhere. I am purposefully ignoring Argentina since it is an ongoing, century-old casualty of policy failures. What is interesting to note is that the linkages of causality between interest rates, internal turmoil, and subsequent contagion are unclear. The roots of contagion within each country originate in policy failure. The resulting contagion may take years to evolve before it turns into a financial explosion that makes the headlines.
Paradoxically, chronic policy mismanagement leads to reduced contagion. Argentina is the world’s premier example of repeated policy failures, where sequential defaults and reconstitutions of governments have led to the dismissal of Argentina worldwide. Argentina no longer causes contagion because its economic actions are now largely uncorrelated to those of the rest of the world. It has isolated itself as an unreliable place, and the rest of the world has “quarantined” it in response. Thus, it will experience its own turmoil and destruction of wealth, with reduced life quality. It will not have much additional impact on the countries around it. Chilean businesses know what they have as a neighbor.
Q-5. Why does one failed policy in a country lead to contagion while a different failed policy does not?
Sequential failures lead to a change in worldview. Just as Greece has recently become the poster child of a failed economy in the Eurozone, Argentina has accomplished the same status in South America. It took years of policy failure in Greece to lead to the crisis that subsequently engulfed much of Europe in a contagion during the last decade. For Europe’s new Eurozone, Greece was the trigger.
In Argentina, policy failures began to occur over a century ago. The world grew to expect repeating failed policies; hence, the contagion risk from Argentina disappeared. In an excellent paper entitled “Argentina: Closing the gap between policy and public opinion” (January 23, 2014), Joshua Rosner of Graham Fisher & Company summarized Argentina’s history as follows:
At the turn of the last century, Argentina, was the eighth-largest economy in the world. Today, according to the World Bank, the country is ranked 73rd in real per capita income. According to Transparency International’s corruption index, it is ranked 106 out of 177 countries (with 177 being “highly corrupt”). Following the World Bank’s cost of “Doing Business” index, Argentina is ranked 124 out of 185 countries. And to top it off, according to the recent World Index of Economic Freedom, Argentina is in the bottom 15 countries in the world and 27th in the region.
Q-6. If a currency exchange-rate crisis is a trigger for contagion, how does it impact business?
Recall the recent news about gunfire erupting in Thailand. As a tourist about to travel to that country, would you go on that trip or change your plan? I will flash back to Argentina. On one of my 15 trips to the country, I watched three presidents take office and then leave office in less than one week. I recall sitting in a Bariloche restaurant as demonstrators marched outside because the banks were closed and they could not make withdrawals. I personally watched the Argentine government fail in its promise to protect its citizens’ money.
The sequence in each country is different, but the impact of civil unrest and turmoil is the same. It quashes business activity, adds financial risk, and spurs agents to store liquidity and value of their assets in any form that is attainable. It therefore leads to economic contraction and payment failure, at which point a contagion multiplier may take over. That is why contagions are unpredictable. In the modern world, we are not always sure who owes how much to whom, when it is due, and how it is to be paid.
Here is an example from BCA Research. Banks in the UK, France, Greece, and Spain have a “combined exposure of US$123 billion” to short-term, private-sector Turkish bank debt. “It is unclear” if this borrowing is hedged, says BCA. “What is certain, however, is that the capability of Turkish debtors to meet their obligations has been seriously impaired by the 60% fall in the lira since 2010.”
Q-7. Does interest-rate policy in the major economies impact contagion risk?
Yes. The normal adjustment process among currencies takes place by means of interest-rate shifts. That is, during periods when interest rates are not anchored close to zero worldwide, interest rates are the adjustment mechanism. Suppose I am a businessman doing business in currency A, and the outlook is for my currency to weaken against currency B by 5% over the next year. That 5% outlook is set by market-based pricing every day. In normal times it will show up in the interest-rate differential between currency A and currency B. If I am involved in cross-border trade, I will make payments in currency B instead of A if I can be compensated with 5 points of additional interest for the transaction. But if this natural interest-rate adjustment mechanism has been hobbled by the actions of central banks, then my transactions may be hindered by uncertainty premia, added volatility, and increased costs or reduced profits; or I may even forego the transactions entirely.
Major central banks worldwide have all taken their interest rates down to zero and held them there for the last five years. They continue to do so as each acts to address its own domestic crisis. Collectively, they weaken the pricing mechanism that would otherwise adjust trade flows between those developed markets and the emerging markets. The result is increased volatility in the foreign exchange markets. That is, when major developed markets anchor their short-term interest rates near zero, they put currency exchange rates in a higher risk mode. That is why emerging markets must be reactive and do extraordinary things with their banking systems and interest rates.
Therein lies the problem for Turkey. It has now taken interest rates to a level that will cause its economy to contract. Furthermore, Turkey will have to examine all of its trade relationships with the surrounding region. Look at where Turkey is positioned geographically, and it is evident how dramatic this adjustment may become.
The same is true elsewhere in the world, because the principle is the same. Interest rates are an arbitraging mechanism among countries and currencies. Take them all to zero, and volatility can explode, as we are seeing now. John Mauldin describes this in his latest newsletter: “Since Chairman Bernanke's first taper warning on May 21, 2013, the "Fragile Five" (Argentina, Indonesia, Turkey, Brazil, and South Africa) have seen their currencies fall more than 15%.” If you take a longer view (3 years), the decline is over 30%.
Q-8. The governor of the central bank of India blames the Federal Reserve for the current turmoil. Some newsletter writers agree with him. Do you blame the Fed?
No. The developed-country central banks owe primary allegiance to their nations and governments. They are creatures of the politics of those governments. Expecting something else is a mistake that investors often make. India has a large economy and is a globally important player, which is why the comments of the new central bank governor received so much attention. Let me excerpt part of a thoughtful response offered by Ed Truman of the Petersen Institute. For the full text see: http://blogs.piie.com/realtime/?p=4225.
When Governor Raghuram Rajan of the Reserve Bank of India, an acknowledged international monetary heavyweight, speaks he makes news. Often he delivers a well-deserved wake-up call. Unfortunately, on January 31, speaking to Bloomberg and as reported in the Financial Times, he sounded the wrong alarm in declaring that international monetary cooperation has broken down and implicitly blaming the difficulties facing a number of emerging market countries on that breakdown. Governor Rajan did a disservice to international monetary cooperation in three respects.
First, he declared that, during the dark days of the global financial crisis in 2008–09, the emerging market and developing countries stimulated their economies through the application of monetary and fiscal policies in order to do their part to support global growth. It is true that many of these countries adopted expansionary policies. It is not true that they did so primarily out of a desire to help the advanced countries. Their principal motivation was to counteract the effects of the global slowdown on their own economies. In the three years before the global financial crisis (2005–07), growth in the emerging market and developing countries averaged 8.1 percent, on a purchasing power basis. During the crisis years (2008–09), growth slowed to 4.5 percent. And it has averaged 5.8 over the past four years (2010–13), not hitting the precrisis average in any year. Emerging market and developing countries adopted the right policies in 2008–09 in their own interests. In doing so, they participated in a cooperative global effort.
Second, Governor Rajan argued that the adoption of a second round of quantitative easing in 2010 by the Federal Reserve, and subsequent similar actions by other central banks, were motivated solely by self-interest without regard for or communication with the authorities in other countries. Governor Rajan knows better. He knows that in 2010 the Federal Reserve’s plans were widely discussed at the annual Economic Policy Symposium in Jackson Hole, at the Bank for International Settlements in Basel, and by the G-20 finance ministers and central bank governors meeting in Korea before the policy change was announced.
More seriously, Governor Rajan failed to answer his own explicit and implicit questions: What should the Federal Reserve and other central banks and governments of advanced countries have done differently? Did those policy actions damage the global economy as a whole, which is not the same as inconveniencing a few countries? By omitting any constructive suggestions, he has effectively contributed to international monetary non-cooperation.
Third, Governor Rajan argued that the Federal Reserve has acted selfishly, in the interests of the US economy alone but not those of the world economy, first, in signaling in May and June of 2013 that the third round of quantitative easing would likely come to an end (taper off) and, second, in adopting such a policy in December 2013. Governor Rajan implied that his Federal Reserve counterparts told him bluntly: We will do what we need to do, what you do is your business, and you should let markets and prices adjust. I doubt this is the case, based on what would be the normal practice of communication among central bankers. On this point, he again failed to articulate what would have been a better and more cooperative Federal Reserve policy over the past year that would have benefitted both the United States and the global economy.
Q-9. Why do some stock markets and countries do better than others when the world faces contagion risk?
Success in fending off contagion depends on the composition of the market and whether the economy of the particular country puts that market at greater or lesser risk as the world goes through an adjustment. Barclays (January 24, 2014) discussed the disentangling of country factors from market composition. Barclays notes, for example, that the Energy sector is 9% of MSCI world market capitalization. However, the sector accounts for only 1.2% of the market in Japan and is completely absent in Germany’s market. At the other extreme, energy accounts for 57% of Russia’s total market capitalization. Globally, the financial industry accounts for 21% of advanced-market and 25% of emerging-market capitalization. The sector ranges from roughly 15% in Germany and the US, to nearly 40% in Spain and China and even higher in Hong Kong.
Look at a mature market like Italy and examine the ETF for Italy (EWI). The largest weight in it (17%) is an energy company, Eni (Ente Nazionale Idrocarburi). Look at Germany, another mature economy. It is evident that the largest two weights in EWG (combined 17%) are Bayer and Siemens. Both of those countries are in the same mature currency zone. Both countries are large weights in that zone and share the same central bank, the ECB (European Central Bank). Between them and among others in the Eurozone, cross-border currency risk comes from their trade flows. Both Germany and Italy are anchored to the short-term interest-rate policy of the ECB.
Compare that to the extreme case of Argentina. It has no anchoring. It has a nationalized energy industry, and the government has essentially undermined it. Alternatively, look at Mexico attempting to revitalize its energy industry by privatizing it. Mexico is closely aligned to its North American neighbor, the United States. Mexico is an example of a country that is turning its trend in a positive way, while Argentina heads into another downward spiral. We might also note that being within a currency zone is a stabilizing influence as long as the trade and financial flows of the zone are part and parcel of those of a larger currency region. A good example is Puerto Rico and its relationship to the US.
The stories about Puerto Rico, its heavy debt load, its recent credit downgrade to junk status, and its cash-flow problems, are widely known. We have discussed them repeatedly. However, in Puerto Rico the citizens are all US citizens. The currency is the US dollar; the banking system has its deposits insured by the Federal Deposit Insurance Corporation (FDIC); and payment flows are in many respects similar to those in the US. Puerto Rico alone cannot cause a global or even regional contagion. Puerto Rico can experience internal reduction of quality of life and suffer when wealth exits to other places in the US; and all that is indeed happening in Puerto Rico because of repeated policy deficits over many years, economic shrinkage, possible corruption, and civil unrest. The key is to look at contagion sources item by item and country by country in order to assess the degree of risk.
Q-10. Does the Fed (Federal Reserve) know all of this? Will it influence their decision to taper?
Yes, of course they know. All major central banks have the skill sets and the data to determine contagion progress. The central banks coordinate their conversations on a regular basis. The Fed reviews the entire world situation in a daily call. I am told that call always includes one member of the Federal Open Market Committee (FOMC), and there is a rotating system for the participants on the call. Staff coordination about international impacts is constantly part of most major central banks’ activity.
The Fed’s tapering policy will only change if the global turmoil becomes a massive new crisis. The Fed wants to maintain a gradual and predictable downward path to bring stimulus back to neutral. It has already taken two steps, reducing $85 billion a month to $75 billion and now to $65 billion. It has led the markets to believe that it will continue on that path for all of 2014.
The Fed wants to accomplish predictability with regard to its policy. It wants to reduce risk premia, encourage US economic activity and the expansion of US employment, and attempt to raise the inflation rate in the US up to 2% from the present level of 1%. Under those circumstances, one cannot expect the Fed to respond to the developing situations in Thailand, Turkey, India, or South Africa. It will look at the economic risks and examine trade flows, but it will not alter its course of action in anticipation of a problem.
The Fed may act differently when and if there is a crisis leading to calls for a response. One can look at 1997 and 1998 as an example. The trouble started in Thailand with its currency, the baht. Its collapse was deemed to be a one-off event at the time, but within a year or so the Russian ruble was in trouble. Long Term Capital Management (LTCM), whose vaunted investment model had not anticipated the Russian "black swan," went critical, threatening widespread banking contagion. Fed Chair Alan Greenspan maneuvered adroitly and arranged an intervention involving the largest US banks. He was worried about the deterioration of credit and capital markets in the US. The process by which the deterioration of the Thai baht led to Greenspan’s intervention in New York took over a year. That is how a contagion works. When it started in 1997, no one could foresee that in 1998 Greenspan would use his power as Chairman of the Fed to intervene and dampen risk in the US financial markets.
The bottom line is, do not count on the major central banks to alter their domestically focused policies in anticipation of rising contagion risk. Their political structures do not allow them to do so. Only after the fact, and after the damage is evidenced, is there a possibility that central banks will intervene and alter policy.
Q-11. Is there a contagion effect when it comes to US municipal bonds?
The answer is maybe. Look at the securities issued by Guam, which has a different political construction from Puerto Rico but is still a tax-free jurisdiction. Guam's debt is trading at a much lower yield than comparably rated PR debt. Both are junk bond status according to S&P; actually Guam is BB- while PR is BB+. My colleague Michael Comes and I reviewed multiple Guam trades over the last few days and observed slight variances in the credit spreads between baseline credits and Guam debt of similar credit quality. Will the market focus on Guam and ask if it is the next Puerto Rico? Will the market distinguish between the political and fiscal situations of Puerto Rico and Guam? We do not know. Only time will reveal the answer to that question, as well as the larger question of whether there is a contagion risk in the municipal bond space of the US dollar currency zone. The key is that contagion intensifies this examination.
High-grade tax-free bonds remain cheap. They yield more than Treasurys of the same maturity. The New Jersey turnpike, for instance, is a monopolistic franchise maintained by a government, and its tax-free bond is backed by pledges sufficiently strong that the holder of the bond will be paid. Why would an investor want to go into an instrument that is taxable when a higher return can be obtained on a New Jersey tax-free bond? It makes no sense not to take advantage of such a security. Contagion risk doesn’t reach to the NJ Turnpike.
But headline risk is different. My colleague John Mousseau has written and spoken about it at great length. Puerto Rico and Detroit are examples. If PR pays, a very high yield relative to anything else will be received. If it ceases to pay, do not get angry because a court had to redo a pledge that was thought to be rock solid. Detroit’s plan for emerging from bankruptcy is a perfect example of how reliable or unreliable a legal construct may be once it is in front of a judge.
The purpose of judges and courts is to referee alternative claims. In Detroit, the antagonists fight over who will get paid out of a limited pot. Bondholders are one of the many claimants. Just because a governing authority issued a bond promising protection does not mean that protection will continue to exist if it is contested before a judge. People who made assumptions about Detroit are going to take haircuts on the debt they held. People who are making assumptions about Puerto Rico may or may not have the same experience.
Q-12. What is an investor to do?
Some principles are important. Stay domestically focused within areas that are familiar to you. Emphasize credit quality. Maintain a cash reserve, because no one can know how a contagion will play out; its trajectory and scope can only be assessed after the fact. Use the cash reserve to redeploy in an opportunistic way as things unfold. The best time to enter may be when things look terrible.
At Cumberland we have made major changes since the end of 2013. The US stock market was a wonderful place to invest last year. Those clients that participated with us are pleased. The market went flat for three weeks starting January 1, 2014, and has been in turmoil ever since. The transition period saw early-warning evidence that a contagion could evolve.
We have a defensive strategy in place at Cumberland. We have a cash reserve that is substantial and higher than usual for us and for our clients. We are overweight in the Utility sector – the first time in years we have taken this sector to an overweight. Why the Utility sector? It provides us with the cushion of an ongoing high yield. The Utility sector comprises domestic businesses that are stable in terms of the products and services they provide. The sector is highly insulated from global activities.
Defensive sectors have a role in portfolio management, particularly when the outlook for 2014 is for single-digit market growth. If the target for the year is 8%, then 4% of that may be obtainable from the Utility sector. The other 4% can be obtained from price appreciation to fulfill the entire year’s objective.
Now let’s move to the credit markets.
At the end of 2013, we watched professional consultants and asset allocators move monies to the stock market and out of their higher-grade bonds. We watched investors who worried about rising and spiking interest rates liquidate mutual funds. In the end, they did what they classically do: they made the wrong move at the wrong time and acted to their own detriment.
High-grade tax-free bonds remain cheap. And now they are in a rally. The key to success in credit markets is clear. Use skill sets to discern credit quality. Not all cities in California are alike, even though they are all cities within the same state. Not all pension systems have made the same promises, even though they all are funding mechanisms for retirees. One must do detailed work on credit and not make broad-based assumptions when it comes to debt markets of the 90 thousand separate issuers in the US.
Let’s sum this up. Contagion risk is rising in the world. It requires portfolio changes, very strong attention to credit quality, and analysis of the details that are embedded in debt instruments. If you are an ETF investor, you must carefully review the composition of the securities within the basket of the ETF. Industry breakdowns must be examined. Find the best places in the markets. Maintain a cash reserve as things unfold, because opportunities are going to present themselves very rapidly. When they do, they must be seized.
We hope most of the questions were addressed. This has been a long commentary to prepare. As the Beatles sang, “It's been a hard days’ night.”
BY David R. Kotok