Finding Relative Value in Emerging Markets

Jacob and Roger explain why, given the current level of uncertainty, it might be wise to look at relative value opportunities within emerging markets.

Finding Relative Value in Emerging Markets

Just a reminder that this is our first paid Lykeion Research piece. Our weekly newsletters and podcast will remain free (for now).


by Roger Hirst

Absolute Risks, Relative Opportunities

The crisis triggered by the collapse of Silicon Valley Bank (SVB) reflects the ongoing risks of a market that is digesting the confluence of inflation risks on one hand and economic growth risks on the other.

Relative value trades may be one way that investors can mitigate these risks.

Today’s investment landscape has been a long time in the making:

We’ve been making the case for a while now that uncertainty is rising. That said, we urge our readers to move past all the noise that stems from such periods of high volatility, which will inevitably mean revert. For longer-term investors, the biggest risk is not short-term asset price volatility, but lengthy periods of economic volatility, where the cycles are shortened, making investible trends fleeting and harder to capitalize on.

The most pressing questions to ask right now are:

This matters because:

Emerging markets are one area that could provide investors with a wide variety of opportunities that are relatively, but not exclusively, less correlated with developed markets.

Now, we know that very few emerging markets will fully escape the direction of travel defined by developed markets, and that’s because developed market investors remain a major source of investible capital for emerging markets (the broad-based emerging market space will therefore ebb and flow with the rise and fall of capital in developed markets). But divergences within different emerging markets can provide investors with relative value opportunities, and thus with the ability to generate returns independently of where the market goes.

Let's get into it...

Increasing Uncertainty

The chain of events that was triggered by the demise of SVB may only be the tip of the iceberg. The storm clouds, however, have been gathering for some time.

In our January report, we noted that:

“Confidently forecasting the economic and market outcomes for 2023 is a tricky proposition because of the vast array of divergent, but equally plausible outcomes. Investors will therefore have to stay nimble.”

You might say that arguing to stay nimble was too general advice anyways, so we shouldn’t get any credit, but the reality is that events are unfolding at a very rapid pace, and a confluence of different drivers is keeping uncertainty about the direction of markets at very high levels.

In fact, volatility on longer-dated yields has risen to the highest levels since the Great Financial Crash of 2008, far above the pandemic-induced levels of March 2020.

bond volatility, MOVE index

There is no room for high-confidence forecasts right now, and you should avoid listening to anyone who believes differently.

That said, remember that the current banking crisis is not an idiosyncratic event. It follows the UK’s pension (gilt) crisis of September 2022 and the ongoing issues across the cryptocurrency ecosystem. Other businesses and industries will inevitably be caught in the crosshairs.

Our view is that:

And so we ask:

Let’s dig in and try to answer these questions.

Inflationary or Deflationary Backdrop? We Don’t Really Know

Before we look at the turmoil in the banking sector, let’s look at some of the underlying features that make this environment so fascinating, but hard to predict (this is not an exhaustive list). There is a vast array of variables to consider, and the below list provides a flavor of the forces at work and the conflicting pressures at play. Inevitably, the outcome will depend on the sequencing. The same policy can be inflationary if early, or deflationary if late.

With so many variables in play, we can have a profoundly deflationary framework (bank crisis, job losses, technology) and yet still have inflationary shocks if the policy includes an element of fiscal support.

It is perfectly OK to be open-minded to both outcomes. In fact, being stubbornly wedded to one is a surefire route to portfolio losses.

Slowly and then Suddenly

Many investors have recently been left nursing significant losses on their bond and mortgage portfolios. Households and businesses will also have to readjust to higher funding costs when their loans mature, or their mortgages reset.

The refinancing of loans and mortgages takes time and is one of the reasons for the lag between inflation, the policy response, and the impact on the real economy and households.

Whilst financial markets rapidly adjusted in 2022, the window of transition from last year’s price shock to a potential growth shock in 2023 initially manifested itself as a positive growth surprise (i.e., the economy was more resilient than expected). This forced the Fed to re-iterate their inflation-fighting credentials in recent weeks, which previously to SVB, forced markets to briefly reprice rates higher, before the dramatic decline in yields witnessed this month.

Perhaps the most interesting element of the recent drama is the speed with which events unfolded. A lossmaking fire sale of a section of Silicon Valley Bank’s bond portfolio led to a failed attempt to raise capital, resulting in a bank run that quickly spread to other regional banks. In our wired world, this happened in double quick time.

Within a couple of days, the 2nd and 3rd largest US bank failures had occurred, and the impact reverberated across the global banking sector.

For global banks, events went from nothing to everything everywhere all at once.

There are elements of both liquidity issues (e.g., a shortage of funding) and solvency issues (e.g., the value of assets falling below that of liabilities) within this crisis of confidence. But at its heart was a concentration of assets whose values were impaired by a sudden rise in yields (these issues were crystallized by the rise in US bond yields that preceded the rise in US interest rates).

If this is a crisis in the management of assets, does it imply a crisis in the asset management industry?

It should not be a crisis for the actual asset managers themselves (though some will struggle), but this may be a crisis for those who rely on the returns of the asset management industry to sustain their standard of living. And there will be certain types of assets and management styles that could be at risk.

Where may some of these risks reside?

Let us ask you: what sectors benefited the most from collecting long-duration assets (i.e., those assets that benefited from the stubborn decline in long-dated yields)?

The answers are not particularly surprising.

Years of Concentrated Asset Accumulation Increase Risk

Supercharged by the ultra-loose policy of the pandemic era, there were over $18 trillion of global bonds with a negative yield by the end of 2020. With the onset of inflation, that has rapidly reverted to almost zero.

negative yields, bonds

While markets reacted quickly to the inflation shock last year (the tech-heavy NASDAQ and specialist ETFs such as ARK saw prices fall), Main Street was largely shielded from markets recalibrating the expectation of higher interest rates.

This is because policy acts with a lag, and Main Street mainly feels the impact of inflation when price shocks translate into economic shocks.

So what are the segments of the market that still need to take a significant hit?

Real Estate

Mortgage rates have fallen for much of the last decade. House prices have risen, not just in the USA, but across the world. Post-GFC, however, lending standards have generally improved, meaning that the customer base for mortgages (and housing) has improved.

Although real estate is typically regional in nature, it is the world’s largest asset class, at over $300 trillion compared to closer to $100 trillion each for bond and equity markets. The global trend toward lower yields and lower interest rates was a long-term tailwind for investors.

The recent reset in interest rates has now impacted the affordability of financing, even for many wealthier individuals. Applications to purchase new homes in the US have fallen to their lowest level in nearly 30 years.

mortgage applications, new houses, residential

House prices should fall, but this does not happen overnight. When Japan’s equity bubble burst in 1990, it took another 2-years before the peak in the property market was clearly in.

Whilst we have primarily highlighted the household real estate market here, commercial real estate also faces similar headwinds. Additionally, the post-pandemic landscape may lead to underutilization of existing floor space as people recalibrate their working habits.

For pension funds that were struggling to hit investment targets in the previous regime of low-interest rates, real estate provided an alternative opportunity. Real estate investment firms were inundated with capital, with some of the bigger pension funds becoming a major force within the space.

If US real estate prices extend their declines today, it should not have the far-reaching consequences that they did in 2006-2008, because the quality of investors has improved, the type of investor has changed (mostly institutional rather than retail), and the use of leverage has diminished. Still:

Private equity firms have been the platform of choice by institutional investors to increase exposure to the real estate asset class. Indeed, private equity (as well as hedge funds) has been the institutional go-to solution for many alternative investments to help offset the lack of returns in many public markets (outside of equities).

Being ‘private’, PE firms have been able to avoid marking investments down to levels that might be implied by publicly traded markets. However, as time grinds by, some re-marking will become inevitable.

Private Equity

Private Equity has become a ‘catch-all’ phrase for alternative investments that include real estate, venture capital, credit, and insurance (as well as the standard PE and hedge fund offerings).

McKinsey estimated in their Private Markets Annual Review that AUM within this space had grown to nearly $10 trillion by mid-2021, with year-on-year fundraising rising by 20% to $1.2 trillion. The biggest PE firms challenge the largest investment managers for total assets under management, despite their solution being significantly less liquid.

Pension funds have poured billions (probably trillions) of dollars into PE mandates, and PE firms have deployed this wave of capital into real estate and technology start-ups. Tiger Global and the ARK ETF are indicative of the risks. ARK (publicly traded) has dropped 75% from its highs. Tiger Global has announced significant markdowns on its book of private assets.

ARK ETF, Cathie Wood

Over a long enough time frame, all investments will be ‘marked to reality’. Grant Williams has written extensively about the problems facing PE. We discussed some of the major issues on our ‘The Ides of Macro’ podcast.

The industry of private equity will undoubtedly ride out the market turmoil, let’s be clear about that. This is a sector that has successfully re-invented itself with successive cycles, and this time should be no different. That said, performance should take a significant hit, and AUM will undoubtedly diminish, with some reputations taking a knock. This might mean more capital will flow again toward public markets. Most importantly though, will be the longer-term impact of bad performance of PE funds on the performance of pension funds, especially given where the funding gap currently is.

Pension Funds

In normal circumstances, higher yields should be a net positive for pension funds because they reduce pension fund liabilities as fewer assets are needed today to generate the required income of tomorrow (i.e., the pensions).

But, during the previous era of low-interest rates, pension funds chased the capital gains that were available on long-duration assets (long-dated bonds, technology stocks, and real estate, all of which rose in price as yields fell). Now, however, those are the segment of the market that will be nursing significant losses.

Unfunded liabilities, pension crisis

Therefore, many hope that the Fed will pivot back to a loose monetary regime before these unrealized losses in longer-term assets are crystallized. That, however, is not a permanent solution.

Value in Relative Value

Now that we understand where the next risks could potentially stem from (real estate and private markets mark-to-market losses leading pension funds returns down the hill), we need to look at what the policy response might be. The next few weeks could be critical in answering that question. Is the banking crisis a sufficient shock for the Fed to pivot and cut interest rates? Or, having just raised rates by 25 basis points in the March FOMC, will the Fed pause and keep rates at the current levels?

See, policymakers face a conundrum.

The banking crisis means that the risk of a hard landing has increased. That doesn’t mean a recession is guaranteed, just that the odds of it have risen. We have noted in a previous edition:

“Recessions are not a good time to be long equities (in their broadest sense). The equity market has made a major low during every recession over the last 50 years.” This is mostly because recessions lead to higher unemployment, and as that rises, portfolios face forced redemptions (which drive asset prices lower). Some of those lows have been shallow (1991), but most have not.

recessions, S&P 500, bear markets

Today’s banking crisis is not an isolated event and long-duration assets are under pressure.

Instead of trying to chase the bottom in the consensus trades of the past decade (long duration), given how high uncertainty is at the moment, we think that relative trades within Emerging Markets are a good place to look for diversified sources of returns, especially as the balancing act of policymakers between a loose policy that supports risk (but may also encourage inflation) and a tighter policy that caps inflation (but also hurts risk assets) likely means that we’ll see the S&P 500 continue to trade within ranges, rather than trend over long periods.

Emerging markets will be impacted, but there will be regions that can avoid the first-order shocks. Relative value pairs within this arena may provide investors with a strategy that reduces risks. Jacob will outline some of those potential opportunities in the next section.


by Jacob Shapiro

Use Geopolitics as Your Emerging Market Compass

This month, we led off with macro because, for the first time since the Russia-Ukraine war started, macro is driving market performance rather than geopolitics. Remember: geopolitics is an analytical framework for understanding the power relations between states. In last month’s Twitter “Ask Me Anything,” Roger described geopolitics as a “slow-twitch” muscle as compared to the “fast-twitch” muscle necessary for investing based on macro developments. This is a perfect metaphor.

That overwrought, metaphorical intro isn’t just because I’ve been binge-watching Ted Lasso lately or because I want to embarrass the soccer fans at Lykeion with my provincial grasp of the mechanics of o jogo bonito. It’s because the downfall of SVB and the subsequent reverberations in European financial markets are boring to geopolitics.

For a financial crisis to have geopolitical import, it has to be on the magnitude of the Great Depression in the 1920s. You can draw a direct line between hyperinflation in Germany due to onerous war settlement terms, the rise of populist movements clothed in various ideological garb (communism and fascism being the most common), a subsequent collapse of global trade, and the events that eventually led to World War II. When financial problems become political crises, geopolitics leaps into action. When a Silicon Valley Bank has a run on its deposits in a rising interest rate environment after over a decade of cheap money, or Credit Suisse finally swirls around the toilet bowl for the last time after years of scandals and problems, geopolitics yawns.

By and large, financial distress like the SVB collapse are fast-twitch issues. If the U.S. government had decided to let SVB fail a la Lehman Brothers in September 2008, I might have sat up in my chair a little straighter – but it didn’t take geopolitics or rocket science to know the U.S. was going to bail SVB out, and any other bank it needed to, to prevent a financial crisis from metastasizing. Same for Europe by the way – but was the final result ever truly in doubt? When $1 billion wasn’t a large enough price tag for UBS to buy Credit Suisse, the figure quickly became $2 billion, and then $3.2 billion. Back in 2012, when Europe faced a sovereign debt crisis that caused far more geopolitical rumbles than the recent troubles in financial markets, the European Central Bank’s Mario Draghi famously said, “the ECB is ready to do whatever it takes.” We still live in the “whatever it takes” era. The countries that have what it takes will spend whatever it takes. Case in point: Europe’s much-exaggerated winter energy crisis. Yes, Europe had warm weather. Europe also had lots of euros to buy LNG on the spot market at whatever price was necessary. The countries that the energy crisis screwed weren’t European – they were countries like Sri Lanka and Pakistan, which couldn’t afford to keep up with the Europeans.

This is also a great example of why macro and geopolitics are complementary tools. If you only used a geopolitical framework and yawned at the SVB crisis, you would have gotten your face ripped off. All the long-term performance in the world won’t do you much good if you lose everything because markets nosedived in a massive panic. If you only used a macro framework, however, you might fall into the trap of bouncing from crisis to crisis. As Roger notes above – the chance of a hard landing has increased, and long-duration assets are under pressure. I quote him: “A confluence of different drivers is keeping uncertainty about the direction of markets at very high levels. There is no room for high-confidence forecasts right now, and you should avoid listening to anyone who believes differently.” But that also does not mean you can or should just crawl into a fetal position and wait for the storm clouds to pass. The storm clouds aren’t going to pass – that is the macro environment, for better and worse.

So instead of jumping from crisis to crisis, you can use geopolitics as your compass for where we go from here. Ironically, geopolitics – which has become popular in recent years due to the doom & gloom of prognosticators predicting everything from World War III to mass famines – can be far more sanguine about opportunities in the future when others are fearful (to paraphrase the Oracle of Omaha himself!).

This is a difficult needle to thread. It is also a great time to whip out one of my favorite quotes of all time, from F. Scott Fitzgerald: “The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function.” Everything Roger wrote above holds – and yet, I want to invite you, dear Lykeion reader, who by virtue of subscribing obviously possess a first-rate intelligence, to hold an opposing idea in your mind at the same time. Namely, the current state of crisis, panic, and fear might obscure what is a slightly longer-time horizon opportunity emerging in specific types of emerging markets – those best suited to succeed in the “multipolar” world I have previously written about here.

Higher rates lead to lower growth and a stronger dollar leads to pressure on emerging markets – but there are other, longer-term forces at work that should be considered as well. Higher rates lead to lower growth, but geopolitical competition leads to shifts in foreign direct investment as great powers divest from less friendly locales to more reliable geographies. A strengthening dollar can upend an emerging market currency over-gorged on U.S. dollar-denominated debt (looking at you, Turkey), but it can also make exports that much more competitive.

Our Framework

When thinking about where to find long-term opportunities given the current backdrop, we are looking for countries that can weather higher rates, where governments can be expected to provide stability and fail-safes if necessary, that are energy-secure or are at least driving down the cost of energy and food, and that are relatively insulated from great power competition. That’s our framework.

If China was the biggest winner of the era of globalization, we are looking for the countries that will be the biggest winners of the era of deglobalization. The attributes described above, either in-whole or in-part, can help emerging markets avoid some of the collateral damage headed their way – and perhaps on a relative basis even out-perform over a period of years. That’s where the slow-twitch of geopolitics comes in – identify the boring, fundamental variables that over time will win over gyrations in global markets.

One of the easiest places to start hunting for these types of opportunities is to follow the money. Foreign Direct Investment (FDI) flows tell you where capital is going. According to the United Nations Conference on Trade and Development (UNCTAD) in 2020 and 2021, the top countries for FDI inflows were the usual suspects – the U.S., China, Hong Kong, and Singapore.

It is the next part of the list, however, that interests me the most. In order, the next six countries on UNCTAD’s report are Brazil, India, South Africa, Russia, and Mexico.

The OECD has slightly more updated data, with up-to-date information for the first half of 2022. Brazil, India, Canada, and Mexico are all in the top 8, and Brazil is as high as #3. Russia saw big FDI outflows, and South Africa stagnated in H1 2022 compared to H2 2021. It is not lost on me that this list is essentially the “BRICS” sans China but with the addition of Mexico. FDI data is also just one variable – but as we look more closely at the data, we will find that this menu of countries will keep coming up.

Another indicator I watch closely is trade as a percentage of GDP – specifically, the sum of exports and imports of goods and services, divided by the gross domestic product. This is a good way of tracking how open a given country is to trade.

Trade as share of GDP, Brazil, CHina, India, Mexico

And yet, even though deglobalization is happening and will be one of the biggest geopolitical trends of the remainder of the decade – not all countries are becoming less open to trade. Indeed, some countries that in the globalization era did not offer China’s unique combination of rule of law, friendly business environment, cheap labor, and a massive internal market are beginning to attract trade and financial interest because their proximity or their politics looks more favorable than those of Xi Jinping’s ambitious China.

This is where deglobalization and multipolarity dovetail. Countries that can play a critical role within a particular geopolitical sphere of influence – like Mexico in North America, or Brazil in South America – have tailwinds behind them that can help weather uncertainty and near-term risk and enable longer-term economic growth even during periods of higher interest rates.

The trickiest variable to keep track of is arguably the most important – reputation. Consider London, which became a global financial center even in the context of the collapse of the British Empire (sorry, Roger) because, between 1945 and 2016 (aka, Brexit), London was seen as the most competitive area in the world in terms of business environment, human capital, infrastructure, financial sector development, and reputation.

Let’s look at a few key examples.

Another example of a country where government policy could lead to outperformance is Indonesia.

Compare this to Nigeria, which has healthy demographics and ample energy resources, but societal cohesion is poor and government performance is even worse. Government policy matters in emerging markets, and countries with poor policy track records are countries to avoid, even if they have all the potential in the world on paper.

A last critical variable to keep in mind for building a geopolitical framework for identifying longer-time horizon emerging market opportunities is to find countries that have energy security or relatively cheap access to energy.

Here, again, Chile is a country that shines (literally) brighter than most.

Venezuela is not an emerging market – if Caracas ever came in from the cold of its pariah status, it would immediately become a compelling frontier market economy – but its massive oil reserves and energy potential are another example of the type of energy resources you are looking for in an emerging market economy. This is where many countries in Southeastern Asia fall short, dependent as they are on foreign energy imports. It is also an argument for countries in the Middle East, like Saudi Arabia, which are rich in hydrocarbons and should enjoy a competitive energy advantage over other emerging market economies as they seek to transform their economies from petro-states to modern industrial and technological powerhouses.

Food security is also an important variable to consider, especially as biofuels play a greater share in global energy mixes, and as such, Brazil – which, though dependent on foreign imports of fertilizer, has plenty of energy and agricultural commodity resource wealth – offers a picture of the kind of economy that can deal with inflation due to its own wealth.

A reminder before the close: This is the slow-twitch take. Geopolitics is a framework that works best over longer time horizons. It is about identifying the variables that will lead to outperformance over time despite the vagaries of markets.

Markets are leading the way right now, and that means we need to respect their power. It also means now is a great time to sharpen geopolitical frameworks, as current volatility will create opportunities to differentiate between which emerging markets can succeed in the 2020s and which will struggle to overcome their constraints. Not all emerging markets are created the same and don’t ignore what markets are telling you – but by the same token, don’t let them scare you off completely. Deglobalization and multipolarity are slow-moving yet inexorable forces, and they will create new opportunities and risks in emerging markets even if interest rates remain high and inflation remains elevated.

Want to use geopolitics as a compass? This is where I’d start looking:

Places where things don't look good:

A reminder:

Thanks for being part of the journey.

As always, we'll see you out there...

Published in: Research

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