Lewis Johnson writes ……….
Soros has specifically identified emerging market debts and currencies as reflexive. It’s easy to see why. The core of the problem revolves around the mismatch between local currency values and a country’s borrowings in foreign currencies, such as U.S. dollars. The act of loaning a growing amount of U.S. dollar debt to a country initially improves that country’s fundamentals. This “improvement” encourages more U.S. dollar lending, especially when interest rates are low back home and savers who are desperate for more income place their capital at unwise risks in peripheral economies.
This virtuous cycle can become a vicious one once incremental U.S. dollar lending dries up, such as after an inflection in credit quality back home (See “Markets Become Dangerous When Investors Become Gullible). Investors discover too late, as Soros notes, that their bonds’ collateral values were buoyed by abundant lending which collapse when credit decelerates. As debtors scramble to refinance, capital flight may depress local currencies relative to the dollar, raising local interest rates and lowering bond prices, which further depress collateral values and economic “fundamentals.” Often the local authorities may attempt to further raise interest rates, in the hope of stabilizing currency values and restarting investment, only to have higher rates hurt the economy.
In Conclusion
Lewis believe that the unfolding weakness in many emerging markets is one of those rare instances of reflexivity’s power. However, just because something can be reflexive, doesn’t mean that it will be reflexive. Frankly, most such potential occurrences abort before they reach the wildest stage of self-reinforcement. That’s why strongly reflexive markets are rare. Yes, they have small odds, but they also bring with them high severity which can drive powerful outcomes. These are often called “Black Swans” because they have low odds but a high expected value.
Investors should regard with caution any attempt by consensus, blind to reflexivity, to blithely dismiss the potential severity of unfolding emerging market weakness. After the crisis has passed, long term investors may prudently expect to find extraordinary values once these forces are spent. We are open to a marked deceleration in emerging market asset prices before a final, buyable low.