Global Macro: Big Risks and Opportunities in Emerging Markets

India and Indonesia are up, Ukraine and Venezuela are down, and Russia poses the greatest risk to political — and market — stability.


The notion of emerging markets as an asset class took a beating in 2014. Rather than moving as a group, emerging markets were all about credit differentiation as elections improved the outlook for countries like India and Indonesia, whereas Brazil, Turkey and South Africa stagnated, and both Russia and Venezuela spiraled downward in a vortex of dysfunction and risk.

Yet even as the world became more varied, global macro traders did a better job at forecasting the outcomes in emerging markets than they did at predicting oil prices last year.

I conduct a survey of global macro traders in London and New York at six-month intervals on what they consider to be the key variables driving financial markets. Back in June, these traders put a 30 percent probability of a balance of payments crisis by one or more of the so-called Fragile Five, down from 43 percent in December 2013. South Africa and Turkey were seen as the most vulnerable, Brazil and India were regarded as being largely out of the woods, and the jury was out on Indonesia as the lame-duck government of President Susilo Bambang Yudhoyono fretted indecisively ahead of last July’s hotly contested election.

Looking back, the 70 percent bet of “no Fragile Five crisis” was right. Despite some volatility in foreign exchange rates, none of these five countries found themselves in a bona fide balance of payments crisis in the second half of 2014. Over the full year, the mean credit default swap rate for these countries dropped from 230 basis points to 180, a reduction of more than 20 percent in perceived risk. Most of that reduction came in the first half of the year.

Yet divergence is alive and well. Since the June poll, Brazil’s perceived risk has deteriorated to just 20 basis points less than that of South Africa, Turkey went sideways, and India and Indonesia took themselves off the fragility watch list. The re-election of business-unfriendly Dilma Rousseff as Brazil’s president on October 26 put the country in a bad light, resulting in a pounding for all Brazilian assets and the real. In contrast, the elections of business-friendly Narendra Modi as India’s prime minister in May and of Joko Widodo, known to everyone locally as “Jokowi,” as Indonesia’s president on July 22 reduced the perceived risk of those Asian countries.

“Some of Turkey’s economic fundamentals remain as shaky as the country’s domestic and foreign policies,” says Wolfango Piccoli, London-based managing director of research at Teneo Intelligence, a political risk consultancy that I chair. “Cheaper oil would help with the current-account deficit, but this problem will not be solved any time soon. The country has now entered a low-growth phase. Whether it can return to a high-growth cycle will be largely determined by domestic politics.”


For all five countries, political outcomes in 2014 helped shape the trajectory of their credit migration — either positive or negative — that will in turn shape how they respond to the long-anticipated normalization of interest rates in the U.S. “Selected emerging markets have little to fear from monetary tightening by the Fed, as they will continue to enjoy the comfort of global liquidity provided by other G-5 central banks,” wrote Andre de Silva, head of global EM research at HSBC Holdings in Hong Kong, in a December research report. “However, not all EM countries will be targets for this global liquidity. Some countries will benefit more, particularly those that are already on the road to reform, which paves the way for positive credit migration. India and Indonesia are two examples. Conversely, negative credit migration has already been evident for Russia, Turkey, Brazil and South Africa in 2014. These sovereigns will continue to be subject to more credit risks and volatility.”

Also from this series:

The Outlook

Our traders have designated a new Fragile Five, with Argentina, Ukraine and Venezuela joining Brazil and South Africa on the list, replacing India, Indonesia and Turkey. They assess a 52 percent probability of a foreign exchange crisis (defined as a currency devaluation of 20 percent or more within a 30-day period) by one or more of these countries within the first six months of 2015, with Venezuela regarded as the most vulnerable and Brazil as the least.

The Brent collapse has a lot to do with this credit migration trajectory. “In the short term, one should not underestimate the potential impact of such a sharp fall on regional economies and companies,” says Michael Hintze, CEO and senior investment officer of CQS. “In the medium term, nations that are net exporters of oil, including Russia and certain OPEC members, are potentially more vulnerable to a sustained period of lower oil prices. A persistently low oil price could affect producers’ ability to maintain domestic infrastructure and, in the medium term, be a force for geopolitical instability.”

For some emerging markets, the fall in oil prices is providing a neat way to dismantle petroleum subsidies that have been a huge fiscal drag without anyone noticing. India and Indonesia are the most notable examples; Jokowi’s draft budget for 2015 slashes petroleum subsidies by 70 percent. So EM countries that have their houses in order, like India and Indonesia, are enjoying a positive reinforcing effect, whereas countries like Venezuela find themselves in an even tighter bind.

The government of President Nicolás Maduro depends on oil for 96 percent of its export earnings and to service external debt. As a result, the price of credit default swaps on Venezuelan debt more than tripled in the second half of 2014, to 3,500 basis points from 1,000 at mid-year. Current levels imply an approximately 75 percent chance of default in 2015. Last month Moody’s slashed its already low rating on Venezuela’s debt by two notches, to Caa3, arguing, “Default risk has increased substantially as external finances continue to deteriorate.” That could scorch any continuing bondholders; the agency estimates that the loss-given-default ratio for Venezuela would exceed 50 percent.

“Maduro’s leadership is adrift, as he appears locked in a pattern of hyperactive inertia, a case in point being his meandering trip to China, Saudi Arabia and other countries,” says Teneo’s Piccoli. “The trip has achieved very little, and those investment pledges that Maduro claims to have secured do not appear to involve cash disbursements that the government can put to use immediately. Reforms to the multitiered exchange rate system that Maduro said would be revealed on January 3 as part of an ‘economic recuperation’ plan have still not been announced.”

Ukraine is No. 2 on the new Fragile Five list. “The place is a financial as well as a political mess,” says one London-based global macro trader. “They are going to be a drain on the EU and on the IMF for a decade.” Eric Fine, emerging-markets portfolio manager at New York–based Van Eck Global, is blunter still. “Ukraine will default, in my opinion,” he says. “However, given that it is considered to be an important U.S. national security priority, official support appears endless, perhaps leading to a less disorderly default. The only problem is that Ukrainian governments have a history of incompetence, even with the benefit of such munificence.”

The International Monetary Fund will support a big, new, long-term aid package for Ukraine if Kiev agrees to economic and fiscal reforms, the agency’s head, Christine Lagarde, said at the World Economic Forum in Davos, Switzerland, last month.

Back in June, the surveyed traders perceived the possibility that the situation in Ukraine would heat up, offering a 34 percent mean prediction of major violence in the eastern portion of the country in the wake of Russia’s seizure of the Crimea in March, but they underestimated just how violent it would became. The June definition of “major violence” was more than 1,000 dead. By year-end, the United Nations put the actual toll at 4,000.

And then there is Vladimir Putin’s Russia. In a thoughtful dissection of Russia’s use of “hybrid warfare” in Ukraine and the uneasy September cease-fire accord struck by Kiev and Moscow, Lawrence Freedman, professor of war studies at King’s College London, pointed out the fundamentally unresolved nature of the conflict. “Russia had damaged, but not defeated, Ukraine,” he wrote in “Ukraine and the Art of Limited War,” an article in the December-January edition of the journal Survival: Global Politics and Strategy. “By sticking to economic rather than military sanctions, NATO and the EU had damaged, but not defeated, Russia. The crisis was not over, because the future of Ukraine remained uncertain.”

Russia didn’t figure as either a financial or a security actor when I polled the traders a year ago about what they would be watching throughout 2014. It came onto the radar screen in the June 2014 survey as a factor in the Ukrainian crisis, but no one was thinking seriously about a Russian financial crisis. “It is humbling to me that the whole Russia-Ukraine thing goes from being invisible a year ago to being the biggest, ugliest bear in the room,” one London-based trader laments. “Why didn’t anyone see this coming? We thought all those dark warnings about Putin were just hand-wringing by superannuated cold warriors.”

At each of the 17 major escalation points of the Ukraine conflict during 2014, from the March 1 Duma passage of the law authorizing Putin to use force in Ukraine to the October 13 shelling of Mariupol, the Russian stock market got hammered, on average losing a full percentage point within 24 hours, according to Kensho, the Cambridge, Massachusetts–based financial analytics company (disclosure: I am an investor and serve on the board). The price of Russian CDS also tracked the evolution of Putin’s strategy, with upticks during the Maidan demonstrations against former president Viktor Yanukovych, the seizure of the Crimea, the aggression of Russian “little green men” in eastern Ukraine, the downing of Malaysia Airlines Flight 17 over Ukraine in July and finally the entry of Russian tank columns in August. By year-end, the cost of CDS protection for Russia debt was four times higher than in January.

Part of this surprise reflected Western sanctions, which few of our traders believed back in June that the Europeans would actually impose. It appears that everybody underestimated the will of Germany’s Angela Merkel, including Putin himself.

Given that experience, traders now see Russia in a new, and darker, light. They assign a 34 percent probability to a Russian banking crisis in the first half of 2015, reflecting the knock-on effects of the ruble‘s roughly 50 percent devaluation over the past year and Ukraine-related financial sanctions.

“There is a perfect storm brewing for the Russian economy that could either end with government-owned companies or with the government itself moving into a default,” Steen Jakobsen, CIO and chief economist at Saxo Bank in Copenhagen, wrote in a recent research note. “Russian companies need to repay $134 billion in debt between 2014 and the end of 2015. This, of course, is backed by currency reserves of $400 billion. Although this may buy Russia some time, the Rotenberg law repaying lost money from sanctions to Russian business owners, the ruble intervention, an incoming current-account deficit, big budget deficits and close to no access to financing from capital markets means that this $400 billion could become petty cash.”

Van Eck’s Fine doesn’t find this alarm far-fetched. “Now that sanctions are legislated, rather than part of executive action, Russian entities have a dramatically lower incentive to repay debt,” he observes. “Why repay if you are never again going to have access to the U.S. financial system?”

I recall walking around the Kremlin on a visit five years ago and marveling at the deep history of Russian martial intervention. The expansion of empire by bayonets and cannon is the central theme of the gilt-laden décor of the Georgievsky Hall, where the president delivers his annual state of the nation address. Putin laid out a counternarrative of Ukraine in his address last month, and his words help explain not just how the crisis developed but also how long the Russian bear may cast a shadow over the global economy.

He denied any causal link between the sanctions and Russian actions in Ukraine. “Speaking of the sanctions, they are not just a knee-jerk reaction on behalf of the United States or its allies to our position regarding the events and the coup in Ukraine, or even the so-called Crimean Spring,” he said. “I’m sure that if these events had never happened, they would have come up with some other excuse to try to contain Russia’s growing capabilities, affect our country in some way or even take advantage of it.” The assembled notables in the Georgievsky applauded on cue.

Then Putin equated the Ukraine sanctions with containment: “The policy of containment was not invented yesterday. It has been carried out against our country for many years, always, for decades, if not centuries. In short, whenever someone thinks that Russia has become too strong or independent, these tools are quickly put into use.” More applause.

Our traders’ mean bet of civil unrest in Russia is just 13 percent, even in the event of a financial and banking crisis. They assign even lower odds to Putin moving on in 2015 — just 1 in 10. Putin is widely perceived to have a firm grip on power, remains highly popular domestically and is unrepentantly defiant of the West in general and Obama in particular. He shares those views himself.

At Putin’s Kremlin news conference on December 18, Reuters’s Alexei Anishchuk asked him point-blank, “To what extent are you confident that your inner circle unconditionally supports you? Do you see any risk of a government coup or even a palace coup?”

Putin fired back with a cold smile. “The official presidential residence is in the Kremlin Palace. It is well protected, which is an important factor for the stability of state institutions in Russia. But this is not what stability is all about. There is no other stability as solid as the support of the Russian people. I don’t think you have any doubts as to whether our key foreign and domestic policy initiatives benefit from such support. Why is this happening? Because people feel deep down inside that we, and I in particular, are acting in the interests of the overwhelming majority of Russians.”

Further EM credit differentiation seems rather far down the list of the president’s priorities. Although the West can pace the bite of financial sanctions, Putin ultimately controls the facts on the ground in Ukraine — what my former colleagues in the Pentagon call “escalation control.” He even appears unconcerned about the risk that the Americans or NATO will supply weapons to Kiev.

“Lethal arms deliveries would impose few additional constraints on Putin in domestic politics, while increasing the risk of a clash between Moscow and NATO in Ukraine,” warns Teneo’s Piccoli. “At home the Kremlin would certainly present this as a major military escalation by the U.S., conforming to the Russian narrative that the Ukrainian crisis is a Western plot. More Russian military casualties wouldn’t influence public opinion in a negative way for Putin. In fact, they could even shore up his already high domestic popularity ratings, as they would help to portray Putin as a determined leader standing up to U.S. aggression and the shedding of more Russian blood.”

James Shinn is lecturer at Princeton University’s School of Engineering and Applied Science ( and chairman of Teneo Intelligence. After careers on Wall Street and Silicon Valley, he served as national intelligence officer for East Asia at the Central Intelligence Agency and as assistant secretary of defense for Asia at the Pentagon. He serves on the boards of CQS, a London-based hedge fund, and Predata, a New York–based predictive analytics firm, and serves on the advisory board of Kensho, a Cambridge, Massachusetts–based financial analytics firm.