Emerging Market countries and companies usually borrow in dollar denominated terms, thus when the dollar goes up as it has recently then it becomes difficult to repay the loan, leading to default. Most EM debt is rated either just below investment grade or else at the lowest rung of investment grade where a sudden small downgrade would push it to a “Below investment grade” (BIG) rating. A shift to BIG rating would trigger a forced sell off of these bonds by some institutional investors making the price on these relatively illiquid securities go down more than they would otherwise be expected to decline. Of course declining bond prices make yields go up, so experiencing rising rates during a time of a global slowdown could trigger a financial death spiral for EM economies, thus hurting Developed countries.
The nature of EM economies is that they either make goods as “contract labor” or “job shops” for a company in a Developed country, or the EM economies make money from commodity production. The risk of a job shop is that it is the “overflow” employer that takes on extra work during booms and then becomes idle during busts. Also they are less likely to have access to the company’s crown jewels of the best trade secrets, technology, etc., so they are easier to sacrifice during a time of layoffs.
The nature of EM debt is that the risk of failure is less diversified and more volatile because these economies lack a diversified economy and the deep pockets of capital and intellectual property, etc. that enable great nations to survive a crash. EM countries remind me of Small cap U.S. stocks that have both more risk and more reward but the problem is to get the reward in Small Caps one must avoid junk quality companies as well as buy when the price is right and sell before the price goes down. If an EM economy is too undiversified, shallow, too susceptible to being exploited as a source of temporary projects or commodities extraction then it may act like a junk quality company, in which its downside risk is greater that it appears.
As risk accelerates and becomes more visible to retail investors then more investment managers will be forced to sell off junk rated EM bonds and this will create deflationary wave for EM economies which will spread globally. Remember when U.S. subprime defaults suddenly accelerated in the Spring of 2007 and Bernanke said “don’t worry, it is contained”? The world economy is highly connected so a default and liquidity crisis in EM countries will spread to the southern EU zone and increase the risks of problems there.
In the Ukraine bond haircuts (a loss of value due to default) are feared with bonds trading at 40% of face value. In Argentina the 2001 default resulted in a refinancing at 38% of face value. A great many previously reliable economic paradigms (like assuming Venezuela was low risk because of its oil) have been disrupted as a result of the commodities crash hurting EM countries, thus elevating default risks.
The challenge for bond investors is that they may not slow down to read the fine print about bonds and may imagine that their portfolio contains only investment grade bonds, only to find out too late that there was a significant concentration of EM debt with BIG characteristics.
The stock market global economy may have topped out mid-2014 and is currently held up by a few “niftyfifty” style giant, glamourous “one decision” bubble top stocks that push up the averages while the median stock languishes and doesn’t move up with the average. What may trigger the EM BIG default could be a rising dollar which could rise another 10% or 25% from 94 on the DXY index to 120 points. If the Federal Reserve raises U.S. rates then the dollar will go up and EM debtors will act to defend themselves, resulting in flight capital into the dollar and then U.S. Treasury rates will go down.
Investors need independent financial advice to reduce risk, heighten suspicion of cherished investment paradigms, and prepare for a crash. I wrote an article “Argentine default – will it trigger U.S. crash?”