What I’m Most Concerned About Right Now – Pain Ahead for the Emerging Markets

I mentioned a few weeks ago that we could be in the early innings of a bull market in the US dollar.  Since the Great Recession in 2008-09, it seems like fewer and fewer assets are trading freely off of their own fundamentals with everything moving together against the US dollar.  Lately, it’s been US dollar up, all commodities and other currencies down.  What concerns me most is the potential for massive shocks this could bring to financial markets, often called “Black Swans” after the book by Nassim Nicholas Taleb.

The Great Recession of 08-09 was so severe because of the amount of leverage (debt) involved.  Everyone and every entity, including governments and banks, had too much debt.  The problem is that leverage works both ways.  When everything is working well it will magnify gains, but the flipside is that it also magnifies losses when market turn against you.  The problem of too much leverage hasn’t necessarily been fixed over the past few years.  It’s just being moved from household balance sheets to national governments around the world, with global debt-to-GDP ratios still on an unsustainable climb higher.  Unfortunately, as we witnessed a few years ago, unraveling over-indebtedness is a very painful process.

The developed nations (Europe, Japan, etc.) seem to be in the worst shape but it’s actually the emerging nations that I’m most concerned about.  While the weakness will most likely start in Europe (the first domino to fall), the emerging nations that have benefited the most with inflows from easy monetary policy over the last decade or so will feel the most pain as capital flows reverse course.

The Background

From 2002 to 2007, the US dollar was on a steady decline and monetary policy was very accommodative.  This created an investment boom in all sorts of assets (e.g. real estate) including investment dollars flooding into the emerging markets.  This allowed many emerging market (EM) nations and corporations to take part in a debt binge with many, if not most, borrowing in US dollars.  Until recently, it has been easier and more trustworthy for them to take a loan denominated in US dollars than their home currency which isn’t nearly as liquid.  Plus, if the US dollar continues to depreciate against their local currency, they’ll end up repaying less than they borrowed when adjusted for the currency change.

Then the Great Recession hit in 2008, there was a “flight to quality,” the US dollar rallied sharply and nearly all EM assets got rocked!  However, Central Banks in the developed nations responded around 2010 by undertaking some rather aggressive monetary easing (called Quantitative Easing) where they began printing money to buy bonds and have been doing so ever since.  This “easy money” has allowed the EM investment flows to continue.

The Problem

The biggest problem facing EM nations is that inflows have primarily been directed into financial assets which can be reversed very quickly.  Debt levels have continued to climb since the Great Recession and issuance of EM debt has picked up quite a bit in 2014 over recent years.  I view this as the last hurrah before the Fed ends Quantitative Easing and interest rates possibly begin to rise (albeit I expect longer-term rates to remain suppressed for other reasons but the view is that the Fed will start to raise short-term rates in 2015).  A similar storyline preceded the Mexican Peso Crisis of 95.  In addition to the expectation of higher rates, the US economy has held up much stronger than most other economies leading to the rise in the US dollar over the past few months.

US Dollar Index (black line) vs. Emerging Markets Currency Basket (blue line) – 1 year

 

This is where things start to get interesting…

If the US dollar continues to climb, we should see emerging market Central Banks utilize measures to stem major outflows because a currency that falls too quickly can lead to a surge in inflation (as it now costs a lot more to purchase food and energy, which are traded/priced in US dollars) and social unrest.  Their typical tools are to either raise interest rates in an attempt to attract investment dollars or to use/spend foreign currency reserves to offset the outflows.

The problem is that many EM nations now have much higher debt to FX reserves which will make it difficult to fight an outflow of capital.  This is setting up the strong possibility of another currency crisis in select EM nations, primarily ones with large current account deficits.  Other nations with a high dependency on oil exports like Venezuela and Russia could also be at risk since lower oil prices means lower inflows/higher deficits.

The Outcome

Unfortunately I think it’s inevitable we’re going to see some major issues ahead for the EM’s.  The severity of the situation all depends on how quickly and to what degree the US dollar rallies.  We could see a wave of defaults in US dollar denominated EM bonds and possibly another currency crises like in the 90’s with the Mexican Peso Crisis of 95 and the Asian Currency Crisis of 97.  It’s nearly impossible to predict when these events will occur or what will trigger them but they always have huge repercussions in the financial markets.  It could be tensions with Russia, a bond default, a hedge fund goes bust, anything…

We’ve been underweight international stocks and bonds for the past year and a half and I plan to remain invested that way for some time to come.

S&P 500 (brown line) vs. Emerging Markets (black line) – 5 years

Emerging Market Bonds Local Currency (black line) vs. US Dollar Denominated Emerging Market Bonds (brown line) – 5 years

Thanks for following!

-Nick

 

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