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Yogi Berra, one of America’s most beloved baseball players, was certainly not a financial professional, yet many of his most famous quips – commonly referred to as “Yogiisms” – should be liberally studied by those of us whose task it is to navigate today’s markets.

After a long and storied career, Yogi was elected to baseball’s Hall of Fame in 1972, the early part of a decade that would offer a toxic mix of slowing growth and rising inflation. Over the past six months, we’ve seen quite a similar pattern in the U.S. economy, leaving investors searching for protection as global equities falter and real yields in fixed-income markets move negative. Indeed, the traditional flight-to-quality framework of seeking refuge in the U.S. is being turned on its head as the ills here, both from real economy and policy standpoints, threaten to contaminate relatively robust global growth.

Déjà Vu All Over Again
It’s a confusing time, particularly in the U.S., as investors look to the past to try to understand the present and forecast the future. For those of us who have invested in emerging markets for a living, we can draw from Yogi Berra’s immortal phrase “It’s like déjà vu all over again” as we see a classic Emerging Markets (EM) balance of payments crisis unfolding before our very eyes – but this time in the U.S.¹

These crises generally start with a country consuming more than it produces, investing more than it saves, or importing more than it exports. Not a bad thing, in and of itself, so long as the investments or imports are generally geared to expand future productivity, thereby enhancing future growth potential. In any case, this excess consumption over production has to be financed in some way; that is, the country has to attract capital inflows to pay for this excess consumption.

Capital flows in from abroad on the basis that it will generate a suitable return, given a level of interest and foreign exchange. If the capital that flows in is used to finance unproductive consumption (a new flat screen TV or even a new house) rather than to promote future growth (investing in a new technology or in infrastructure), lenders over time will demand more and more compensation for their monies [i.e., higher rates or a weaker starting currency (FX) rate]. Worse still, if lenders lose confidence that a suitable return can be gained from their investment in local currency terms, they will pull their money out.

Until that happens and while capital is pouring in, vulnerabilities take hold in banking systems that are flush with cash and continue to make loans assuming liquidity will continue unabated. This excessive credit growth is attracted to the hottest sectors of an economy – in the U.S. it was real estate – and generally creates a massive bubble that isn’t pricked until the liquidity vanishes. Unfortunately for the U.S., the fallout is usually both lengthy and costly: historical evidence suggests that banking crises in developed countries take, on average, between four and five years to resolve (see Figure 1). As Yogi so famously said, “It ain’t over ‘til it’s over.”

This Time, It’s Different
How do these crises usually play out? In an EM country, financing for the current account would wane as fears grow that the deficit is “unsustainable,” the currency would plunge in an attempt to find a level that would attract inflows or make the country’s export sector competitive again to balance trade accounts, and the banking system would implode under the weight of non-performing loans and as depositors rush to take out deposits and seek safety in the U.S. dollar (USD). The final chapter of this story in EM is a debt crisis, accentuated by debt composition denominated in hard currency, that may lead to default as the cost in local currency terms of servicing that hard currency debt soars.

The U.S., thankfully, doesn’t suffer from a currency mismatch in its debt composition. All those U.S. Treasury bonds are denominated in U.S. dollars. So, no default, right? Right – technically speaking.

But years of running large and growing current account and fiscal deficits have created a huge debt burden in the U.S., one that may grow substantially worse as problems with Fannie Mae and Freddie Mac make their way onto the government balance sheet, and as social security and health care deficits mount. And so while investors in U.S. Treasuries will get their U.S. dollars back on time, the “default” will occur when the value of those U.S. dollars gets eroded as confidence in the dollar wanes, and as inflation moves higher while the Fed is forced to keep real policy rates negative to support an economy in shambles. Pretty soon, as Yogi says, “a nickel ain’t worth a dime anymore,” so to speak.

Anchors Aweigh
Much of the discussion about the global implications of the U.S. crisis has focused on the impact on global growth, with the U.S. consumer going out of commission. That is surely important, but for a bond investor a more nuanced issue is also critical: the fact that in recent years, U.S. monetary policy has been an anchor for the monetary policies of many emerging market countries. With that anchor gone as the U.S. Federal Reserve focuses on preventing the U.S. financial system from falling into a depression-style downward spiral, many EM countries find themselves anchorless.

The negative externalities from the loss of this anchor are transmitted through two main channels. First, developing countries, and especially those in Asia and the Middle East running heavily managed currency regimes, have effectively imported U.S. monetary policy. As the U.S. deals with its subprime-mortgage, credit-crunch, old-fashioned consumer recession crisis, monetary policy has been kept loose. This is fine for the U.S. as it seeks to stave off recession, but it is wholly inappropriate for emerging markets that are growing in aggregate around 7% and whose inflation has picked up to double digits in many cases.

Second, investors seeking refuge from falling U.S. markets and the weakening U.S. dollar have been pouring investment dollars into and pushing up the price of commodities, particularly oil and gold. This coincides with high levels of commodity demand from the emerging world that has been fanned by government subsidies. As fuel prices surge, these distortions spark second-round effects in the U.S., where the inefficient use of bio-fuels like corn-based ethanol is being promoted and drives up the cost of food. Effects are also being transmitted on the ground in EM, where export restrictions on food have exacerbated global shortages and, as the fiscal damage from subsidies becomes intolerable, costs are being realized through higher inflation. Simply put, the U.S. and emerging market economies “made too many wrong mistakes,” as Yogi phrases it.

Thus unfolds the first true test of many emerging markets’ inflation-targeting regimes, adopted over the past five years or so, when disinflation was being driven by the huge surplus of labor from China, India and Emerging Europe. Indeed, according to Morgan Stanley, eighteen emerging markets now run explicit inflation-targeting regimes. Of these, just one – Brazil – currently has inflation within its targeted range. Sounds like a pretty poor track record until one realizes, as Morgan Stanley also points out, that only one of the eight developed central banks running inflation-targeting regimes has inflation within its target (and it’s not the European Central Bank)!

Some of the worst slippages on the inflation front are in Asia and in Emerging Europe, where real policy rates have moved sharply negative in the face of recent inflationary shocks (see Figure 2). Policy makers have been hesitant to address potentially transitory jumps in headline food and fuel prices with sharply tighter monetary policy for fear of engendering a growth slowdown. Instead, many seem to hope that measured monetary policy tightening coupled with favorable year-over-year inflationary base effects will leave monetary policy appropriately tight a year from now.

Credibility Matters
This is a risky assumption, especially considering the inflationary pasts these governments have been seeking to expunge and the present battle against inflation expectations that threatens wage-price spirals. Indeed, according to JPMorgan, wage growth in EM surged 13.2% year-over-year in the first quarter of 2008, accelerating by more than 2% over levels seen in the same period of 2005 through 2007 (see Figure 3).

To combat wage-price spirals, policy makers have an array of tools at their disposal including both “price-based” and “non-price-based” levers. The latter (including controls on goods, capital and credit) have been utilized by a number of countries to try to minimize the risk of collateral damage to growth, but have been ineffective to this point in quelling the inflationary impulse.

On the flip side, unfortunately, implementation of price-based controls including 1) interest rate hikes, 2) allowing more FX appreciation, or 3) tightening fiscal policy has not been strong or fast enough. Nominal rate hikes haven’t kept pace with the move in inflation, FX appreciation has become increasingly difficult to engender as developed world growth falters, and some countries unfortunately have been moving the other way with fiscal loosening as subsidies have been expanded. Policy makers’ tools are most effective when forecasts are accurate, but as Yogi says: “It’s tough to make predictions, especially about the future.”

What remains clear, however, is that EM policy makers are facing a tough decision between inflation and growth. Those that choose to maintain high growth and sacrifice the inflation fight in the short run will likely find a more difficult path in the long run. These countries face heightened risk of macroeconomic and political volatility, as well as reduced financing flexibility as local markets close (implying a less robust debt structure and deteriorating sovereign creditworthiness).

Shelter from the Storm
What do you avoid and how do you invest in these uncertain times? Yogi says “You can observe a lot just by watching.” Stay away from fundamentally weak economies and the financial assets within them that will bear the brunt of the collateral damage of the crisis. At the top of that list are the U.S. dollar and long end U.S. Treasuries. To repeat the point made earlier, the U.S. is undergoing an old-school balance of payments crisis, but without the FX mismatch. The risk from here is a disorderly correction in the exchange rate, and higher inflation. The United Kingdom looks similar to the U.S. in many ways and the pound seems particularly vulnerable to a correction given the weakness in both the banking system and real estate. Within EM, converging Europe is characterized by twin deficits and dangerously high debt levels. These, combined with potentially explosive mismatches in the FX composition of that debt, make converging Europe (particularly Hungary and Romania) a prime candidate for a disorderly FX adjustment like the one that threatens the U.S.

Concentrate investments in the economies with credible policy anchors and balance sheets strong enough to help them weather the storm. At the top of this list is Brazil, with local bonds a particularly attractive long-run investment. Five-year bond yields are close to 14% in Brazil, with inflation running close to 6%. The Central Bank has cemented its credibility by raising rates aggressively to ensure inflation returns to target. This provides investors a unique opportunity to receive high interest rates in investment grade credit, with credible monetary policy, prudent fiscal policy, solid balance of payments dynamics and political calm (compare this to the U.S. case above). Asian FX (particularly Singapore dollars and Chinese yuan) also offer good risk-reward ratios in this environment, as balance sheets are in many ways the mirror image of the U.S.

In Yogi’s words, “when you come to a fork in the road, take it.” Extremely good advice for investing in a world where the crisis is centered in the developed world, rather than in EM.

Michael Gomez
Executive Vice President

¹ Eleven years ago, it was Asian countries that were running large current account deficits, using easy financing from abroad to fund an investment boom in real estate. Unfortunately this over-investment was not productive, and when investors saw that the investment would not generate returns to repay the debt incurred, a crisis ensued.