Emerging market stocks + currency mismatch

I am not too fond of the label ”Emerging Markets”, at least not in discussions about investment opportunities. I mean, what, exactly, is an emerging market? And which countries should count as emerging? Another thing that is often misused, or misunderstood, is buy/sell recommendations. Very often you hear someone recommending a buy or sell for this or that stock without adding a time horizon. I mean, isn’t it possible that a stock could be expected to fall more before it starts climbing? Yes, of course! Also emerging markets stocks…. I will come back to this particular issue in the last paragraph below.

Anyway, this entry is not about these naïve observations. Instead, what I want to highlight is a rather unknown (I think) negative (sell) observation that is applicable, first and foremost, to emerging country stocks. As of lately, many emerging market currencies have weakened dramatically against particularly the US dollar. Whether we are talking about BRICS or MINTS or any other group of up and coming countries, weaker commodity prices, the slowdown in China and the bizarre monetary policy in rich western economies have put a lot of pressure on their currencies. So far so good! Everyone knows this and everyone expects this to continue for some time with the trillions of dollars that flowed into these countries now possibly departing. Everyone also knows that this could be a problem since household plus company debt now roughly equals total GDP in these emerging markets. And, unfortunately, much of this debt is in US dollars! This amount is higher, even, than the amount of debt in the developed markets before the financial crisis.

Now, what my (very timely, indeed) research shows is that dramatic currency falls, of the size seen recently in many emerging markets, coupled with actual historically observed currency mismatches in company books in selected emerging markets, could lead investors (and banking regulators) to materially underestimate the actual company credit risk. While it is obvious that the default probability increases if the debt is issued in a foreign currency and the assets are in local currency, my research shows that the increase in default correlations due to the mismatch is very important as well. For more on the latter issue I refer to Byström (2014) The impact of currency movements on asset value correlations. Journal of International Financial Markets, Institutions and Money, Volume 31, July 2014, Pages 178–186. That paper looks at the asset correlation bias resulting from firms’ assets and liabilities being denominated in different currencies. It focuses on the time-variation in the bias and on the dependency of the bias on currency movements.

So, again, regardless of whether you are optimistic or pessimistic about emerging market stocks I think my research should be acknowledged. I do not think the increased credit risk is priced (fully) in the stock market, particularly for local EM banks, and it should therefore bias any stock market forecast downwards. Personally, referring to the first paragraph above, I believe in emerging markets stocks (whatever that means…..) in the longer run. Based on the discussion above on currency mismatch, however, I think (ceteris paribus) that it would be wise to wait some time before one increases the proportion of emerging market stocks in one´s portfolio. If I had to make a prediction it would be that 2017 or so could be a good time to enter the market. Earlier if the prices drop quicker than expected and later if they hold out. In other words, I am pessimistic in the short run and optimistic in the long run. It is obviously possible……

Caveat emptor!

Chinese News, English News and the Chinese Stock Market Crash

In my research I am not only working on credit and credit risk but I also focus on financial stability, performance measures, commercial microfinance, and market behavior in general. I have also written academic papers on the use of news aggregators in finance. Considering the recent Chinese stock market correction, my latest paper on this topic turned out to be very timely! In the paper Byström (2014) “Language, News and Volatility” I use Google News to study the relation between news volumes in both English and Chinese and stock market volatilities in China and elsewhere.

In collect more than nine million stock market-related news stories in English and (Mandarin) Chinese and find that the stock market volatility and the number of publicly available global news stories are strongly linked to each other both in English- and Chinese language. The relationship between news and volatility is weakest in mainland China, however, and a possible reason for this is that Chinese retail investors do not read traditional news, neither in Chinese nor in English.

Interestingly, the other day I read an article about Chinese authorities allegedly telling Chinese media not to use words such as “slump” and “collapse” when reporting on Chinese stock markets! To avoid volatility and panic! This is fascinating news for me who scan the media universe for exactly those words, in Chinese, when studying whether stock market-related news is related to stock market volatility or not. Maybe the authorities have also realized that news and volatility are closely associated?! But maybe they have not read my paper that shows that the link is weakest in, well, China!!!

I guess they have to find some other way to boost Chinese share prices.......

Insta Fashion

Some weeks ago I attended an interesting conference at Lund University named “Shopping Asia”. Among all the topics that were discussed, there were some interesting presentations on Fast Fashion. Fast fashion is a term used to express that designs move from catwalk to consumers very quickly in order to fully capture current fashion trends, enabling mainstream consumers to buy current clothing styles at a really low price. H&M, Zara, Forever21 are examples of company names that are associated with fast fashion.

One thought that I got when listening to the talks was that there seems to be an ongoing race towards the bottom! A race that takes us from Fast Fashion to Insta Fashion (my term for really cheap clothes that the Instagram generation buys for Saturday night). It is like a second wave of fast fashion, where the journey from drawing board to shop floor is a day or two instead of several weeks.

What would the implication of such a second wave of fast fashion be for the environment and for working conditions (back home)? And what would the implications be for investors? On the first question I think it is likely that conditions will grow worse rather than the opposite. Bar a revolution, there does not seem to be anything that is able to stop the worsening of working conditions in the west. At the same time, it is possible that lower wages and insta fashion’s demands for local manufacturing could lead to more job opportunities in richer countries. And for the environment fast fashion seems like a very bad idea, for obvious reasons. The second question is possibly more interesting (for us). How will a potential race to the bottom, if it exists, affect us investors? Possibly, private equity investors and the likes will be able to invest in portfolios of insta retailers and be able to gain if the idea fully takes hold. For the rest of us, who do not have the financial muscles to buy entire companies the only hope is that listed firms such as H&M and Inditex will successfully adapt to a possible shift in the anatomy of the fast fashion industry. I think that could be one important point to scrutinize for any retail analyst. Or, if you are a firm believer in insta fashion, perhaps the Boohoo stock which is trading at 28 GBP, down from 70 GBP a year or so ago, is ripe to be picked? I wouldn’t know…..

Kreditmarknadens åsikt om volatiliteten på aktiemarknaden

Ett nytt ”Byströms Börstips” titulerat Kreditmarknadens åsikt om volatiliteten på aktiemarknaden har publicerats i LINC MAGAZINE #7 2014 s.36-37. Börstipset kan hittas här och handlar om hur man kan prediktera aktievolatiliteter över längre tidsrymder. Detta kan vara användbart om man t.ex. vill veta vad sina personaloptioner som löper ut om 10 år egentligen är värda idag. I en sådan situation är historiska volatiliteter inte särskilt användbara samtidigt som implicita aktievolatiliteter från optioner med flera års löptid typiskt saknas.

Börstipset bygger på min artikel Stock Prices and Stock Return Volatilities Implied by the Credit Market där jag föreslår att man i stället för att förlita sig till aktiederivatmarknaden vänder sig till kreditderivatmarknaden. Ett typiskt företag är ju finansierat dels med aktiekapital och dels med lån (krediter). Detta gör att såväl aktieinvesterare som långivare har goda skäl att noga övervaka och analysera företagets verksamhet. Och det, i sin tur, gör att inte bara företagets aktiepris utan också dess lån- och obligationspriser är användbara indikatorer på marknadens tro om företagets väl och ve. Med andra ord, inte bara aktiederivat utan också derivat på företagets obligationer och lån är starkt kopplade till företagets framtida med- och motgångar.

Is the stock market really overheated?

As of lately I have got numerous questions from friends, colleagues and students as to whether I think the stock market rally is getting close to an end. The arguments are always the same: S&P is at its all-time-high, stocks all over the world have been lifted by ultra-low monetary policy, company earnings are declining and geo-political concerns abound. In addition, many commentators and “experts” in the media, not only the perma-bear journalists of mainstream business news but also various seasoned investors, claim to be concerned.

I would like to make one small contribution to this discussion. Particularly since I am sometimes, mistakenly, taken to be a local Dr Doom. It can be summarized in one short sentence: measured in the only hard currency there is, gold, S&P500 is neither cheap nor expensive at this point! Look at the two attached graphs. The first graph shows gold and S&P500 from 1968 until today, measured in US dollars. And the second graph shows S&P500 measured in gold instead of US dollars. There are two points that I want to make:

1) Seen over the (really) long term the cost of buying gold and the cost of buying shares of US companies has increased with roughly similar amounts.
2) According to price history, the price of a piece of corporate US is not cheap when counted in number of gold bars. However, it is not excessively expensive either!

Of course, there are many issues with this simplistic analysis. While S&P500 has changed since 1968, a gold bar is still a gold bar, at least from the mid-70s onwards when the US legalized gold possession. Also, gold prices fluctuate a lot and some of this could of course be due to market overreactions.

Predictions are always difficult, particularly of the future! On one hand, the last time S&P500 cost 1.5 Oz of gold was in September 2008.... :( On the other hand, the second last time S&P500 cost 1.5 Oz of gold was in 1995... :)