How to parachute through a sudden stop

Douglas Adams, author of The Hitchhiker’s Guide to the Galaxy, once observed: “It’s not the fall that kills you. It’s the sudden stop at the end.”

Economists have their own interpretation. “Sudden stop” has become a widely adopted term for an abrupt slowdown, or reversal, of capital flows to emerging markets. The stop tends to come with severe economic repercussions.

Common consequences include sharp currency depreciations, banking crises, recessions and corporate bankruptcies. And, as would be the case in Adams’s analogy, the potential harm increases with the height of the fall.

Sudden stops strike predominantly in liquid, higher-risk asset classes such as emerging markets. Studies have found they are preceded by large portfolio inflows, meaning global investors are piling into shares and bonds in the emerging economy. As this goes on, the emerging economy becomes increasingly dependent on foreign financing, while foreign investors accumulate a larger stake in the local financial markets.

And while portfolio inflows happen gradually, the stop is, well, sudden.

This is relevant for SA. Between 2000 and 2015 the average net foreign purchases of South African shares and bonds amounted to R40bn a year, adding up to more than R600bn. The current value of these investments will be even greater due to capital appreciation.

The R600bn number suggests we have plenty of distance to fall should the foreign appetite for South African assets suddenly dissipate. A prudent investor should monitor developments in these portfolio flows. History provides some guide as to what factors should be on our radar.

Sudden stops are typically triggered by a global tightening of monetary policy or unexpected events, such as the Russian default in 1998 or the 9/11 terrorist attacks in 2001, which increase volatility and risk aversion.

In today’s environment, however, monetary policy has remained ultraaccommodative for years, volatility is low and investors appear ever hungry for risk. But this may be turning.

The US Federal Reserve has signalled three hikes to come in 2017, the first of which was delivered in March. The European Central Bank is expected to taper its quantitative easing policy in 2017. Even the People’s Bank of China has indicated it will remove monetary stimulus.

A large co-ordinated effort to tighten global monetary conditions would have the potential to cause market volatility and a loss of risk appetite.

In other words, all the conditions for a sudden stop of capital flows to SA could potentially be triggered in the near future. What’s more, data from 2016 suggest this may already be under way. The outflow in 2016 from local equities was five times as large as the average annual inflows over the preceding 15 years.

While these numbers are staggering, the market response was muted for several reasons. First, the portfolio outflows were cancelled out in practice by the AB InBev acquisition of SABMiller.

It is also relevant that much of the outflows were explained by foreigners selling their SAB shares prior to the delisting. If we ignore all outflows in the beverages sector, the net portfolio outflows amounted to R57bn in 2016, according to data available from the Reserve Bank and the JSE.

Due to the offsetting effects of the SABMiller delisting, we have not yet seen the classical market response to a sudden stop. Typically, this would include a sharp depreciation of the currency and falling asset prices. Instead, before the cabinet reshuffle, we saw the rand strengthen about 5% in 2017 and 16% since the start of 2016.

Local equities have been quite flat since the start of 2016. Global volatility is at a record low, with realised 90-day volatility on the S&P 500 index at 7% versus average volatility of 16.5% over the last 30 years. Market data does not suggest disruption.

However, we can’t dismiss the risk of a sudden stop based on the lack of market symptoms alone. First, we cannot rely on transactions such as the SABMiller acquisition to cushion the blow of future outflows. Second, data on flows and the global monetary policy cycle must be considered.

The question then is whether we will see a fully-fledged sudden stop with all the associated consequences; a gradual winding-down of positions by foreigners with no severe consequences; or continued appetite for South African assets and continued positive performance of the rand, local equities and domestic bonds.

While markets remain complacent, investors should ensure their portfolio is sufficiently diversified to withstand a turn of global sentiment. Or you may simply choose to look at the bright side: we are just falling, and falling doesn’t kill you.

SUDDEN STOPS ARE TYPICALLY TRIGGERED BY A GLOBAL TIGHTENING OF MONETARY POLICY OR UNEXPECTED EVENTS