Mispricing Sovereign Risk
Sovereign risks in developed countries are ill-perceived, belittled and often ignored altogether. This is in major contrast with emerging markets (EMs) where risks are routinely seen to be larger than they actually are. The distinction is fundamental: EMs can be defined by such shared prejudice.
They are otherwise highly heterogeneous – much more so than the countries which comprise “the developed world” – which helps explain why many people (not me) from time to time argue that the EM label is no longer relevant.
There is some history of course, which I detail more comprehensively in Chapter 1 of my book “Emerging Markets in an Upside Down World”. Until the late 1990s (specifically the Russian crisis in 1998), EMs did have something else in common not shared with the developed world: they were similarly vulnerable to external shocks due to their high dependence on foreign capital, much of it highly levered and subject to sudden outflows.
Since then, though, many EMs have become net creditors. Also their bond markets are now dominated by long term unlevered institutional investors, many of them domestic. Thus they are no longer distinguishable by their exposure to possible financial contagion, which is now a global not EM characteristic. Indeed, financial contagion is now a much greater risk in the developed than the developing world, as evidenced by the much higher developed world indebtedness, dependence on external creditors and, of course, events in 2008.
It is however axiomatic in the minds of many that EMs, by definition, are always riskier than developed markets.[1] To sustain such nonsense in our heads and remain sane it is necessary to use different criteria to assess political and other components of sovereign risk in EMs to those used for the developed world. The easiest way to do this is just ignore things like political risk in the developed world.
Many of us know this discrimination to be real (and unjust), but how come such seemingly irrational risk assessment and associated behaviour nevertheless appears so normal and sustainable? We know that EMs get a raw deal, but we also know that as long as everybody else behaves as if they should, then it makes some sense to behave likewise.
Financial markets are trend-amplifying scale-free networks. Being scale-free networks they have a number of highly connected and influential hubs. The hubs in scale-free networks are robust but if attacked can cause catastrophic collapse. A highly connected individual bank failure can cause huge contagion. Bank regulators now understand this, even if they have not done enough yet to avoid a 2008 repeat, as well as that high indebtedness across banks can exacerbate vulnerabilities.
With that vulnerability in mind, some of the most important events in financial markets can best be understood as resulting from changes in perception, in particular changes in long and widely held rules of thumb or in world views. These are the triggers which can lead to attacks on hubs and so to catastrophic change.
Just as margin calls and rumours of collapse can kill inter-bank lending, so a change in perceived risk can cascade across markets causing chaos. Financial sector vulnerabilities exist in the realm of ideas, just as fashion can switch suddenly in other realms. Greater connectedness amplifies the potential speed and scale of catastrophic events – much more than in previous periods of history, even very recent history.
Hence we need to understand our vulnerabilities not only in terms of excessive and systemic financial sector leverage, but also our mass belief in unsustainable nonsense.
How does one identify mass delusion though? A clue is that we often (not always) recognize it after the event – i.e. after our mass delusion has been dispelled, possibly through the catharsis of a catastrophe. Indeed, our delusion can be extremely obvious after the event and yet puzzlingly we didn’t see it clearly at the time for some reason.
Yet we know that herding occurs and that the pull of the consensus can even defy the evidence of our own senses. So the problem may not be that our senses are lying to us, but rather we are overriding them through our strong incentive to copy the consensus.
Translating this to sovereign risk assessments, it is our capacity to belittle and discount known aspects of reality, not just our ignorance, which causes our skewed perception. Ignorance, after all, would be a lot easier to fix. It is much easier to acquire knowledge, even involuntarily, than to alter prejudice.
So just as the best hiding place can also sometimes be in the centre of our field of sight, so well-known but discounted possibilities may yet not be priced into markets. The Brexit vote was predictable. Mr. Trump’s election victory seems much more foreseeable after the event. Yet many saw both as highly unlikely.
So occasionally we should metaphorically pinch ourselves. Opinions about risk and the place of EMs in the risk hierarchy are so established as to seem hard-wired. But all prejudice is vulnerable to change.
Plan B
Which brings us to discuss President Trump’s economic plan. A number of policy initiatives so far have substantial associated economic risks. Both the Senate and House are co-operating with the Administration in approving appointments, and should not be expected to limit substantial Presidential power. Fiscal expansion can thus be expected. If growth is not induced via increased corporate sector investment, as I have discussed in this blog previously, the likelihood is that market concerns over fiscal imbalance will rise. Central banks have already started selling US Treasuries heavily (my last blog). Others will follow. A substantially weaker dollar may result. A bond crash is even possible, as is a rapid shift to an inflationary scenario.
Plan B can then emerge – as the IMF and others have been saying for some years, the dollar is over-valued and growth inhibitive. If investors are happy to buy government bonds at next to no yield there is an argument for issuing as much as possible until the penny drops, the dollar falls and the cost of paying back the debt is reduced. Mr Trump is no stranger to corporate default. Countries which issue bonds in their own currencies default by other means.
The lower dollar will then stimulate growth and the message from the White House may be that the substantial competitive devaluation is payback for all those currency manipulators who for years have been competing unfairly with the US. The President could also claim that this was his plan all along (plan A not B) and he is so much smarter than everyone else, and that markets couldn’t see what was going to happen, even with so many clues.
And that is why investing in EMs is a smart way to REDUCE risk.
[1] A derivative of which is the idea that the US is “risk free” and EM sovereign bonds always trade at higher yields than, and with reference to US Treasuries – i.e. that the spread over Treasuries is more stable than the bond price, and the comparison with the US yield curve more important than relative risks. This may be true for extended periods due to the collective beliefs of market participants rather than actual risks or potential losses, but is far from a uniformly safe assumption. US risk is not zero, the Dollar is not risk free, and the Federal Reserve is a domestic (not global) interest rate setter. Indeed, not only have US Treasuries seen many periods of much higher volatility than EM bonds, but when the EM bonds are not Dollar-denominated some EM sovereign spreads have been negative.
By Jerome Booth