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Notes on emerging markets and market liquidity

September – 2015

Emerging markets form an important area of interest for us. We find these markets at the center of a very explosive cocktail[1]. The ingredient list could cover a page in small font, but the largest three are: the Chinese slowdown, energy/commodity cycle and, the least recognized but certainly not the last, the extreme asset-liability mismatch of the investors who hold these assets (to a large extent US mutual funds – more about this in a later post). We find the current rhetoric about emerging markets confusing, which is usually an indication of opportunity. As a continuation of our plan to discern substance from noise, we spent the first part of October of last year in Latin America, invited by the organizers of a selective politico-economic meeting. There we met with Mauricio Macri, then presidential candidate, spent time with Chilean think tank leaders and had numerous discussions with economic experts in virtually all emerging and/or troubled markets, including Venezuela, Eastern Europe, Russia, MENA and China. We came home with a better understanding of the economic and political landscape in the region.

From a market perspective, this trip consolidated our view that the biggest issue plaguing markets today – fixed income market above all – is structural and two pronged. On one hand there is bank regulation that virtually eliminated intermediaries’ (like banks) appetite or capability to house assets. On the other hand there is a pervasive attitude of elevated risk taking on the traditional buy side, mostly institutional money managers hungry to lure as much as possible of the QE-born, yield-hungry money supply. For the past two years we have repeatedly argued publicly about the danger these well-known and widely owned investment houses/vehicles (mutual funds, ETF’s, etc.) pose to the fixed income markets, due to the mismatch between their increasingly illiquid assets and their daily – or instant in the case of ETF’s – liabilities. During the past two years we have developed in our research department a proprietary conceptual framework and systems for analyzing liquidity risk.

We can now perform several types of analyses, from simple to very detailed, for any investment vehicle, across any asset class, without requiring the knowledge of any underlying holdings.   The great usefulness of these systems is that they allow us to discern not only hidden risk factors (some of them hailed as “smart beta” by some investment firms…) but also changes in these factors over time and in various liquidity environments.

[1] A black hole physicist would call this a singularity, i.e. the point where extremely large amounts of matter are crushed into an infinitely small amount of space. Singularities are very interesting because they are something small that become something infinitely large.

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