Odd Lots - Why So Many Emerging Markets Are Blowing Up Right Now

Episode Date: January 6, 2020

From Argentina to Chile to Lebanon, we're seeing a high degree of political and economic uncertainty among emerging market economies. On this week's Odd Lots podcast, we speak with Paul McNamara, a veteran fund manager at GAM Investments. McNamara explains why this moment is so turbulent, and what it will take to settle these economies down.See omnystudio.com/listener for privacy information.

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That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. And I'm Tracy Allaway. So Tracy, obviously 2019 for sort of mainstream risky assets like stocks in developed markets has been a, it's been a pretty good one. Yeah, I think we're ending solidly up on the year, it looks like. Yeah. One of the weird. One of the weird. things, though, I would say, is that despite the, you know, on the surface, everything looks good or growth, I guess, is okay. Stocks are up a lot. There are a lot of things around the world this year that maybe in another year would be seen as more systemic or troubling, all kinds of hot spots and

flare-ups and protests, basically everywhere you look. Yeah. So as someone who's in Hong Kong and has been for the past six months. One of the really remarkable things about this year is just how fast we've seen social unrest basically spread around the world. I think Hong Kong was the first place where it really cropped up this year, but then we saw lots of protests in South American countries. We saw them in the Middle East yet again. And a lot of these are still taking place, of course, and it takes a while to sort of get through the impasse with protesters. Yes. And there's all these protests, you know, they have multiple causes, but each is in some level inextricably tied to something in the economy. Maybe the economy or some economic decision is a

spark, of course, everything is very complex, but all kinds of things related to public subsidies and pension systems and cutting of government support for various domestic programs. They seem to frequently play a part in the unrest. And of course, that feeds into the perception of economic and financial stability everywhere that you see these things flare up. Yeah, I totally agree. There's always an underlying economic trend in a lot of the dissatisfaction that we're seeing around the world. No, absolutely. So today on the podcast, we're going to be speaking to an investor who's been looking at world markets, emerging markets for a long time, knows a lot about how these types of things play out or how they don't play out, maybe learn something about the connection between unrest,

fiscal problems, financial stress, bond markets, and how investors can think about these situations. Yes, I like this one. And before we start, we should just throw out there that one of the really interesting things about all this social unrest and how it affects the fiscal situation of countries is that when it comes to debt sustainability, we don't really have an overarching bankruptcy regime for the world, right? Every country is sort of different. So you never quite can be sure how these things are going to play out. And each country might experience a very, very different outcome. Exactly right. So with that, with at intro, I want to bring back Paul McNamara. He's a portfolio manager at GAM Investments. He's

been on the show before one of our favorite people to talk to here. So Paul, thank you very much for joining us. Thanks very much for having me. So, interesting year in your line of work, huh? Certainly has been. I mean, you know, apart for, I mean, I think Lebanon is probably the one in terms of social unrest. But international investors always, I think, you know, make good villains in the, you know, for evil capitalism. And I think, you know, in terms of sovereign debt, there was a thing in the, in the New York Times recently when a bunch of hedge funds tried to stop Puerto Rico from spending money on sort of protecting the population from storm damage so that they could repay in full the debt that the hedge funds had bought in the

40s. So, yeah, it's an interesting place to be. Well, why don't we start with Lebanon? We're going to sort of bounce around from place to place, I think, given that we are talking about emerging and frontier markets. But I'm particularly interested in Lebanon, because I remember when I was out in the Middle East, you know, every once in a while when you were talking about debt sustainability with an analyst or when a piece of research crossed my desk, it would say something like Lebanon has a public debt to GDP ratio of something like 150%, which is really, really eye-catching and probably worse than the vast majority of even emerging market countries. And yet every analyst, every research note would kind of swat that away as not really relevant for the time being. And yet

something has changed this year. And suddenly everyone is very, very worried about Lebanon's situation. What was the catalyst for the current crisis? Yeah. I mean, it's hard to put your finger on. I think once the government really realized that push was coming to shove, I mean, like you say, Lebanon's ratios have been absolutely horrific. We usually look at, for example, a current account deficit or a budget deficit of 6%, 7% of GDP as being unsustainable. Lebanon's current count deficit is around 25% of GDP. I mean, most of these ratios are completely off the charts. The reason why I think people have kind of said, oh, well, Lebanon's different is they've been in the wrong place for a long time. I mean, as Joe kind of noted, I've been doing this job

for a long time. And even in the late 90s when I started out doing this, Lebanon was already running some very peculiar numbers. But what's happening, I think, with rising rates, I mean, Lebanon is the one country. I mean, Ponzi scheme or pyramid scheme are terms which get thrown around a lot, you know, and often very unfairly. But I think Lebanon is one country where that accusation really begins to stick. Because what happens is that Lebanese either non-residents or sort of non-residents claiming to be residents or, you know, that there's not, you know, huge transparency in where the money comes from, bring their money into Lebanon and, you know, instead of running, you know, sort of yield getting, say, 1%, 1.5%

on a dollar deposit in a bank anywhere else, you're getting 9, 10% on dollar deposits in the Lebanese banking systems. So people thought that was a great trade. They brought their money back. Basically, the government spent the money. the central bank used the money to prop up the peg of the Lebanese pound at a touch over 1,500 to the US dollar. And it was the classic situation. The currency became uncompetitive, huge trade deficits as huge amounts were imported.

But every year, you know, the country needed not just to finance the current account deficit, but also, you know, very significant redemptions of foreign debt. And what's happened this year is that foreigners stopped being willing to roll over the debt or the Lebanese or whoever, it was, it was the end user of these debts. So the banks became absolutely desperate for those foreign dollars. And at that time, the supply of those dollars also dried up. Now, that could be associated with some fairly unpopular kind of austerity measures, including, I think, attacks on WhatsApp conversations. You know, it's easy to kind of to point to 100 different things, which had always looked unsustainable, actually became unsustainable. And you've got some very strange

situation's happening at the moment. There are no formal capital controls on the Lebanese economy, but there are de facto controls that if you want to take a large cash deposit, you'll find that you're restricted to maybe a couple of hundred dollars per day to take out of a bank. It's very difficult to make transfers abroad. That a dollar in a Lebanese bank is absolutely not worth a dollar in any other bank. Although the official rate for the Lebanese pound is in one place, there's a gray market where the bit sent cheaper. So it's all the signs that you quite often associate with countries going wrong. You know, the official rates deviating from the practical rate. Theoretically, you can move money around in practice. You can't. So, but yeah, I mean,

what's, it's the old thing, you know, what can't go on in the end won't go on. And Lebanon looks to be moving much close to that moment of truth. This dynamic that you mentioned in which Lebanese banks were offering extremely high rates of interest so that foreign holders of dollars would bring their money back into the country. Is that unusual? Or is that something that you see from time to time in countries that have very high demand for hard currency? It's a bit retro, really. I mean, it used to be much more common because it's something that you typically associate with pegs. So, you know, go back 20 years and nearly every country. I mean, effectively all the countries in Asia, most of Latin America, had pegs to the dollars or mixed pegs to the dollar and the yen and the Deutsche mark as it was then.

But, you know, as all the, you know, as peg after peg broke with, I think Russia in 1998 being the most glaring example of this thing of paying up massively for something linked to a dollar, it's really, it's a very unusual thing to see these days. There are very few pegs left in the world. But yeah, it's something that we've seen in many places before. And once you get to that point where X number of Lebanese pounds or a dollar in Lebanon aren't the same as a dollar offshore, that's when things start to spin out of control quite quickly. So the implication here, I guess, is that the Lebanese central bank was basically underwriting the country's banks and sort of encouraging them to suck in foreign influence. flows so that it could maintain the peg. Exactly. So does that mean that banking or a financial crisis is now basically inevitable in Lebanon?

Inevitable is a word to use very carefully about Lebanon. It certainly left to itself, I'd say it's absolutely inevitable. What we find a lot of people are placing their hopes on are the Lebanese looking for a sponsor, you know, either the Saudis or the Iranians. I mean, domestic politics in Lebanon is really very complicated, but the various richer energy exporting states are often seen as maybe a sort of a magic, well, I suppose a sovereign sugar daddy, which could be, you know, which, because Lebanon is a small country. That seems the only plausible way out. Certainly the IMF or any of the other global lenders would be most unlikely to allow that to. go ahead, you know, to pump money into the economy without seeing something to address the underlying imbalances.

You mentioned the uncompetitiveness of the currency. What is the, I mean, in theory, when you hear about uncompetitive currencies, you think about, okay, that choking off some sort of domestic sector, some domestic, say, export sector. What if in a sort of more properly managed or more flexible currency, What is the main potential for Lebanon to improve its terms of trade? I think it's got great potential as a service center for the Middle East. I mean, historically, you know, before the rise of Dubai, Lebanon was a big trading center, you know, and trading centers like Hong Kong everywhere else have gone on to be the financial capital of their regions.

I think the Civil War and various other things in Lebanon are the reason, you know, why that didn't happen there. you know, it's a very attractive tourist destination, very well-educated population. I mean, there are plenty of areas where the country could maybe be more competitive. And also there's a very large diaspora. And in many other countries around the world, just, you know, foreign remittances are enough to keep an economy going. But, you know, looking at Lebanon now, and even allowing the fact that, you know, a substantial recession is pretty much guaranteed in the event of the peg breaking, a devaluation of something, you know, effectively, say, halving the value of the currency really doesn't look like much of a stretch here.

So a devaluation is essentially a debt restructuring in this context. And I did promise that we were going to talk a little bit about international bankruptcy regimes or the lack thereof, the mechanism by which these actually get resolved. And one of the interesting things about Lebanon is that it has issued debt to international investors. and I think some of those bonds do have collective action clauses in them. So are we going to get a sort of repeat of the Elliott Argentina situation here? Look, it's very likely that they're going to try.

I mean, the stuff that's at risk of the Elliott Argentina situation is really the older debt, because most collective action clauses, you know, if you get about three quarters of the debtors together, and most of this debt is held by, or a very large proportion of this, debt is held by Lebanese banks or Lebanese residents, especially the older bonds which don't have these collective action clauses, because what you tend to find is that vulture investors choose one or two specific issues and try and own a blocking stake in those bonds rather than hoovering up sort of odd bits of the bonds at a few cents in the dollar. I mean, at the moment, the Lebanese debt is generally sort of trading, you know, high 30s or 40s,

not really down at the level where distressed investors would find it interesting. I mean, a lot of the debt that Elliot bought in Argentina, we think, was trading your sort of 20 cents in the dollar or below. But absolutely, it's vulnerable. You know, especially, I mean, if you've got a cack, it's fine. 75% of the investors agree. And then the remaining 25 have no choice. They're automatically sort of bailed in. But it's the older bonds which don't have these clauses, which I think are particularly vulnerable.

And, you know, we've seen it in Greece as well. You know, there have been other cases where foreign law bonds. are effectively senior and that the investors get paid in full. Paul, you mentioned there that even though we've seen a pretty dramatic drop in the price of Lebanese debt, it's not yet trading at distress levels. Why is that? Because again, when you look at the actual metrics for the country, it's really, really hard to see how it will get itself out of this situation. So why isn't the debt being valued as such? It's very hard to say. I think there's you know, there's a certain residual belief in, you know, sort of the sugar daddy from

the Gulf. The yields are sort of high teens now or low 20s. It's quite an expensive thing not to be invested in and a very expensive thing to be short. They have got significant reserves. So, you know, there's every chance that even if things do ultimately go wrong, they could certainly postpone default for a year or more. And I think it's the combination of those uncertainties. But certainly, you know, given these prices, I'd rather be a. seller than a buyer of Lebanese debt. Today's show is brought to you by Vanguard. To all the financial advisors listening,

let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds,

actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio, all investing is subject to risk vanguard marketing corporation distributor. I have a weird question, and it's going to be kind of a curveball, and it's something that I wonder about from time to time,

but it's just something on my mind just now. You know, every once in a while, you read about some country that's in some sort of extreme distress, the running out of money, the banking system is running out of dollars. We were talking about that with Turkey a couple years ago. Things quieted down. Why is it so rare for countries to just completely collapse la Venezuela? Like we all know and have Venezuela in our head,

just a country in which everything is gone. But that's pretty rare in the grand scheme of things. And so, you know, you might get some extreme recessions from time to time, but you rarely get all-out economic Armageddon, even when the math looks horrible. I mean, you get degrees. I mean, Argentina in 2001 was another thing, you know, where, you know, there were fears of people going hungry. Fortunately, the country is a huge food exporters. They had surplus food. I think in Iceland, we came very close to the edge there. they were lucky in that, you know, they have ample power, you sort of hydro and geothermal. But yeah, countries in the wrong place where things go absolutely wrong.

I mean, Venezuela, it took years of work. It took over a decade. First Chavez and then Maduro until you got the country completely reliant on the oil price being kind of north of $100. So once it dropped much below there, the situation was completely unsustainable. I mean, these countries are very unpleasant. places to be, you know, and very, very unpleasant places to be poor. I mean, even though Turkey's gone quiet, there's a lot of people living very miserable lives. But I think, you know, just the

political pushback that once a country gets, gets right close to the edge, you do need effectively a secret police, which is what you've got in Venezuela, to prevent the government being overthrown and replaced by something more rational. So I think politics is probably the only answer I can really come up with there. So, Paul, we've done Lebanon and a little bit of Venezuela, but of course, the other country we wanted to ask you about is, of course, Argentina, which is in the midst of, it seems like they're talking about yet another debt restructuring. What's the most likely outcome there? And I guess my biggest question for the Argentina situation is why do international investors continue to buy Argentinian debt, even though it's defaulted

several times? I think the greater fool theory that, you know, a lot of international debt investors. I mean, the vast majority of international debt investors, the key question is, you know, will this be more expensive or will I make money over the next month, regardless of whether this is sustainable in the long term? I mean, if you look at the Argentine century bond, which, you know, even that, people who bought it at issue, if they, if they were fairly nimble, managed to, manage to make a little money at least, I think that you're just not paid to punish a country for past sins. I mean, Absolutely. I think sovereign debt investors are chronically optimistic. You know, last time around in Argentina,

they borrowed an absolutely phenomenal amount of money and sort of drove Argentina's ratios up the wall. But I think just the incentive horizon for your average debt investor is a lot shorter than it takes a country to go bust. So, Paul, we've seen this return of trouble in Argentina. Obviously, you mentioned Lebanon. We're also seeing it elsewhere in South America. America right now is similar issues. You see issues in Chile, Colombia, and elsewhere. And I'm curious, so in the developed world, and we've been talking a lot about it on this podcast lately, in fact, in the developed world, there's no doubt that there is a lot of debating and rethinking sort of conventional macro wisdom. And this idea about how best to stabilize the economy, the role of monetary policy versus fiscal policy and so forth. The sluggish growth post crisis has caused a sort of rethink. Are we due for something like that in the developed world? Because you see these

sort of tried and true efforts. The IMF comes in. It has some package. It fails inevitably or it fails frequently because the terms of the package run up against domestic politics. Or you see some country in vain trying to hold to some peg and this idea that I'm not sure what. Is EM macro stability in need of a broader rethink? Very good question. You know, I don't have a good answer. I mean, clearly political tolerance is being stretched, you know, by this long period. I think especially in the Anglo-Saxon economies, we haven't seen wages rising.

Right. We've seen massive inequality. It's, you know, it's worked very well for the wealthy. It's worked much less for everybody else. And, you know, and clearly the cracks are beginning to show, you know, things like Brexit in particular, which is a hobby horse of mine. Oh, I haven't noticed that. The triumph of the triumph of populism, I think, owes a lot to that. I think, you know, the big question for the Western countries is, you know, is what's the impact of the next recession,

where, you know, instead of people sort of seeing, you know, all the wealth accrucing to a few people are suddenly sort of struggling to meet their mortgage payments and stuff like that, I think that's when, you know, some very serious questions are going to be asked about, you know, whether you can have, and this is the question, you know, whether you can have political stability when the economy is working for the majority of people. I mean, this was, I think Chile is the best example of that, you know, because it is the one which is most purely economic, is that the Chilean economy at a macro level has been doing very, very well, certainly better than almost any other economy in South America over that period, but the gains have overwhelmingly accrued to a few people.

And I think, yes, I think there are definitely questions DM and EM about how long that's sustainable for. And I think a period of macro stress is going to make those questions much more glaring. But the difference is, and I think this is why Chile you get a lot of demonstrations, which I think may eventually quieten down. Unlike Argentina, unlike Lebanon, unlike Venezuela, countries with monetary sovereignty can hang on a lot longer, you know, that they can print the money without completely debaseable. their currencies, you know, and all the countries that we're talking about are really countries which don't conform to, I'm not a huge believer in MMT, but the idea is that it only applies to monetary sovereigns, and, you know, none of those countries are by anybody's definition monetary sovereign. So I think monetary sovereigns can probably hold out a lot longer.

Paul, Joe very diplomatically said you were an experienced emerging market investor in our intro. So I'm just curious, is there anything about this year or the past year, 2019, that has actually surprised you in your emerging market experience, something that you weren't expecting? The thing is that we've got this far without more serious problems in other places, you know, that we've had a long period of stability. And I think the same with everybody else. It's been the longest period since God knows when without a recession. That kind of Lebanon and Argentina, they're very significant for the people who are there. But in the context of global markets, they're tiny, you know, sort of, you know, and even as debt markets, they're much smaller than Brazil or Russia or Turkey. So I think the fact that, you know, that it's all been in very small, marginal countries, you know, all countries with very specific problems like Venezuela has been the surprise.

I think, you know, the fact that Turkey was able to pull itself back from the brink very quickly, that Brazil has been able to cut interest rates, you know, to an unprecedented degree. Markets are really pretty relaxed. And that's what I think we've been struggling with a bit. You know, you mentioned when we were talking about Lebanon. And of course, it absolutely applies to Argentina and the whole saga with Paul Singer. How important is having good legal expertise to investing in these markets, to understand exactly what you're buying? I mean, it helps. I mean, I think, you know, most people in my position would know how to read a, or not how to read,

but we would have a grasp for some of the concepts. And if we didn't, we've been educated over the last few years. I think a number I'd throw out there is that, you know, having been sued for 10 years by Elliot, that Singer's Vulture Fund, the Argentine government actually ended up paying his legal fees, which were, if I remember, right, about $235 million. So, yes, good legal advice is worth an awful lot. I mean, just as a note, I think Singer bought debt with a face value of around $400 million.

They paid less than 20 cents on the dollar, and they took back, we think, sort of over $2 billion was what Argentina ultimately ended up paying them. So, yeah, getting your legal advice straight is really worth quite a lot. Paul, one last thing. I remember, you know, I think the last time we had you on, I think we were discussing the crisis in Turkey, and your timing about when that would turn. I mean, you just mentioned they brought themselves back from the brink. It was very good. And I want to just sort of go back to this idea that for people who aren't in the weeds on this stuff, but who are interested, what are the things that you look for specifically that say, even though the headlines may look, awful in a country, this, the some sort of corner has been turned such that they can return to some sort of stability or sustainability. The awkward truth is that, you know, for a balance of payments crisis, specifically, a big recession, and to be honest, a recognition that the recession is inevitable is usually what fixes these things, because you fix a big external deficit by imports collapsing, not

by growing exports. I mean, people love to say restoring competitiveness, but it's not. not having the money to buy imported goods, usually sort of 80% plus of the improvement comes from a collapse in imports, which means a domestic recession. So once we see, you know, things beginning to adjust, a big drop in property prices, we see activity slowing down, we see interest rates going up, you know, that this recognition that, you know, that there is a reckoning is usually a sign that at least the problem is being addressed and that the worst will soon be over.

As a corollary to that, is it a warning sign of who might be the next in the line of crisis if economic expansion is associated with a dramatic widening of the trade deficit? Exactly that. That combination of very high domestic credit growth and a big external deficit. That's definitely something that we look for as a country where things are going wrong. Paul McNamara, great to get your perspective, and we'll have you again on in another year to talk about all the new crises that will inevitably pop up in 2020. The latest emerging market crises. Yeah, there's going to be something new, so looking forward to get your perspective.

Thanks, Paul. Okay. Bye. Thanks very much, fuck. Thanks, Paul. So, Joe, I always love talking to Paul, partly because he brings, you know, decades of experience to any discussion of emerging markets. I think decades. But I think it's also really important to get like the actual investor side of things to explain some of the dynamics. So his point about how investors aren't actually paid to punish a country for past mistakes and that it's actually very expensive to avoid investing in some of these markets, I think is a really important one.

Yeah, I think so too. I mean, because it's easy enough to look at a country like Argentina and say, oh, I don't know how many dozens of times they've defaulted over the last century or whatever. But, you know, this idea that maybe investors aren't all complete idiots and still have reasons to invest in a country, despite that trek record, I think makes a lot of sense. Yeah. And the other thing, a lot of this reminded me of, well, A, I think your question about whether or not there needs to be a new paradigm for emerging markets is a good one. and it definitely brought a lot of flashbacks from my like international political economy classes in university. But B, the notion of, you know, large parts of the world actually being tied very closely to the U.S. dollar and thereby the Federal Reserve. So, you know, Paul mentioned at the very beginning that part of what sparked Lebanon's crisis was just the rise in interest rates in the U.S., which kind of caused its problems because it, of course, has a pegged currency.

Well, exactly right. You remember we had our episode with Alphado Kaboob, and Paul was saying you're not really a big fan of MMT. That's fine. Nonetheless, this idea that the sort of paradigm view of which we think emerging markets must grow, which is export competitiveness, currency, stability, and so forth, you know, it continues to get tested. And this idea that, you know, we do, I do think we have this macro rethink in the West, a recent episode where we talked with Robert Skidelsky was very much about that.

It does feel that, you know, you look at these situations like, again, Argentina and however much the IMF sunk into that program. And you wonder whether a much deeper discussion needs to be had about how macro stability in emerging markets. Yeah, absolutely. And the interesting thing is I think there have been some noises coming out of the IMF and certain policymakers in Washington about rethinking some of these programs and some of the approaches to debt sustainability. So interesting stuff going on. Yeah, interesting stuff, interesting times. Great to talk to Paul. Yes, indeed. All right. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Allo. And I'm Joe Wisenthal. You can follow me on Twitter at the stalwart. And you should definitely follow our guest, Paul McNamara. He's on Twitter at M underscore Paul McNamara. I think many people agree one of the most interesting and insightful people around on the space. And be sure to follow our producer, Laura Carlson, at Laura M. Carlson, as well as this week's substitute producer Tofor Forges. He's at Forges T. Be sure to follow. the Bloomberg head of podcast, Francesca Levy, at Francesca Today, and check out all of Bloomberg's podcasts.

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