Hedge funds bet against emerging markets

Hedge funds bet against emerging markets

Hedge fund managers are positioning themselves to profit from a slowdown in developing economies, led by overheated credit markets in China. A number of them are buying protection on sovereign debt through credit default swaps.

Since the start of the 2008, China’s ratio of credit-to-GDP has exploded. London-based hedge fund investor Noster Capital believes it is now at higher levels than those seen on the cusp of the credit crises in the US and UK in 2007, Japan in 1990 and Korea in 1998.

Noster’s estimation is based on levels of business, household and local government debt in China but does not include bonds issued by the central government.

Pedro de Noronha, founder of Noster, told Financial News: “China is a very leveraged economy and a lot of the assets that are against the leverage are not cash generative. China is relying on the shadow banking system as a Ponzi scheme to let it roll over credit. The cracks in China in the past couple of weeks could well be the canary in the mine shaft.”

Concerns around leverage levels are being compounded by fears that China could be overstating its growth. Patrick Wolffe, managing partner of US hedge fund Grand Master Capital, pointed out that in the west GDP is “calculated on a final sales basis” but that China bases its figures on levels of production.

He said: “In China, you can build a building and you don’t have to sell it to have it counted towards GDP. Under that system, the government can mandate growth but that growth may not accurately reflect general economic activity.”

Kevin Kenney, co-founder of New York-based hedge fund Emerging Sovereign Group, outlined his bearish view on China at Goldman Sachs prime brokerage’s annual conference in Rome last month, according to two people who attended the conference.

ESG, which manages about $4.5bn in assets, is currently raising money for Nexus, a $20m China-focused macro portfolio that it launched in June last year, according to an investor who has been briefed on the plans.

The fund has bought sovereign credit default swaps on China to express its bearish view. In a China "hard landing" scenario the fund could make 100%, while it could lose 30-40% if its bearish view doesn’t play out, the investor said. A spokesman for the Carlyle Group, the majority owner of ESG, declined to comment.

Other hedge fund managers are betting on a wider slowdown in emerging markets.

Dr Ray Bakhramov, chief investment officer at NY-based Forum Fund Management, said: “People have high hopes on continuing growth in emerging markets but now there is likely to be a re-pricing. It won’t be a death but a two-to-three-year cyclical negative turn, similar to 1998.

“The big difference this time around is that these are large countries and just as people have overestimated their ability to grow, people have underestimated the effect of their slowdown on global growth.”

Between 1998 and 2012, global GDP grew from $30.2 trillion to $71.7 trillion, according to the IMF World Economic Outlook Database 2013. Over this period, emerging and other economies grew from 23% to represent 41% of the global economy, while advanced economies shrunk from 77% to 59% of the total.

Bakhramov said the most vulnerable countries are South Africa, because of its political instability; Russia, from an economic perspective because it is a mono-exporter of energy; and Korea because it is very leveraged to a slowdown in China. He said that Forum Fund’s strategy for these markets was based around CDS and currency trades.

Managers said they were attracted to credit default swaps because of the attractive risk/return profile they offer - the downside is limited but the upside can be multiples of that. According to the most recent data from the Depository Trust & Clearing Corporation, China, Brazil and South Korea are among the top 10 countries with the highest number of CDS contracts written against their sovereign debt.

Forum’s $180m fund owns a basket of CDS on South Korea, South Africa, Brazil, Turkey, Australian corporates and Japanese corporates. In the basket there are also a number of shorts on emerging market corporates, which are highly geared and sensitive to drops in commodity prices and GDP slowdowns.

The fund is also short Lebanese sovereign bonds and long Qatari sovereign CDS to play the theme of geopolitical uncertainty in the region.
Bakhramov said: “It is likely to happen in waves. It is a two-year trade not a one or two month trade.” He added that a four-to-one payout ratio is Forum’s target return profile for the risk it positions.

Noster’s De Noronha said he owns CDS on emerging markets sovereigns.

De Noronha said: “The trade has a very asymmetric risk/reward profile. A gigantic wall of money is on the other side of the trade and all of them have the illusion that they will be able to get out just before the others. Emerging markets is the asset class that is most dependent on liquidity and they have had loads of it with quantitative easing in most G7 countries.

“As we are nearing the point that that excess liquidity is withdrawn, the first and biggest casualties will be emerging markets, where the unsophisticated money has flooded in the search for yield and where the risk/reward is probably one of the most unattractive ones that existed in the past decade or so.”

Investors have continued to pull money out of emerging markets amid concerns that the US Federal Reserve will begin tapering its bond-buying programme. For the week ending July 3, emerging markets bond funds posted net outflows of $956m, according to data provider EPFR. An additional $284m flowed out of emerging markets bonds funds on July 4 and 5.

Bakhramov said: “Once investors start to take money out of emerging markets it will lead to economic deterioration and further outflows. When the vicious circle starts, governments will become more leftist and there is the risk of political instability.”