I have been, and remain, bearish on emerging markets for three reasons:
- As discussed yesterday, the U.S. is closer to the next economic downturn than not. When the U.S. enters a recession, emerging markets are hurt considerably more given their dependence on the U.S.
- International risks in countries like Turkey, Greece, Spain, France, Italy, etc.
- A strong dollar from flows into U.S. Treasury bonds for a “safe haven.”
I recommended in January of this year to remove all international and emerging market exposure from portfolios and have been updating that position since each week in the newsletter:
“Emerging and International Markets were removed in January from portfolios on the basis that “trade wars” and “rising rates” were not good for these groups. With the addition of the “Turkey Crisis,” ongoing tariffs, and trade wars, there is simply no reason to add “drag” to a portfolio currently. These two markets are likely to get much worse before they get better. Put stops on all positions.”
This has been the right call, despite the plethora of articles suggesting the opposite.
For example, in January, Rob Arnott stated:
“Look at value in emerging markets. In the U.S., value is trading about 25% cheap relative to the market. In emerging markets, it’s close to 40% cheap.
That’s pretty cool. If you can buy half the world’s GDP for nine times earnings or buy the U.S. for 32 times earnings, I know where I’m going to put my money.”
Now, I am not arguing Rob’s point. But, my position is simply that the economic dependency of emerging markets on the U.S. is extremely high. Therefore, when the U.S. gets a “cold,” emerging markets get the “flu.”
Over the last 25-years, this has remained a constant.
In 2000, 2007 and 2012, emerging markets warned of an impending recessionary drag in the U.S. (While 2012 wasn’t recognized as a recession, there were many economic similarities to one.)
Currently, emerging markets have once again diverged from the S&P 500 suggesting economic growth may not be as robust as many believe. While a 2-quarter divergence certainly isn’t suggesting a “financial crisis” is upon us, it does suggest that something isn’t quite right with the global economic backdrop.
Lisa Abramowicz recently noted the problem with EM default risk in some of the emerging markets.
While the markets are currently dismissing Turkey, Brazil, China and Russia as non-events, the problem is the issue of funding needs for these countries.
“The second, more salient point is that a key reason for the solid growth across emerging markets in recent years, has been the constant inflow of foreign capital, resulting in a significant external funding requirement for continued growth, especially for Turkey as discussed previously.
But what happens if this outside capital inflow stops, or worse, reverses? This is where things get dicey. To answer that question, Morgan Stanley has created its own calculation of Emerging Market external funding needs, and defined it as an ‘external coverage ratio.’ It is calculated be dividing a country’s reserves by its 12-month external funding needs, which in turn are the sum of the i) current account, ii) short-term external debt and iii) the next 12 months amortizations from long-term external debt.”
Given the ongoing pressures of “tariffs,” trade wars and rising geopolitical tensions, the risk of something going “wrong” has become increasingly elevated.
Yet, market participants are ignoring the risk simply because prices are rising. As Doug Kass noted yesterday:
“There is nothing like stock price advances to change sentiment.
Just like fear dominates politics these days, the opposite is occurring in the markets as greed has emerged as a byproduct of sharply rising prices (which have desensitized investors to risks, doubt, and fear).
Besides growing economic ambiguities, the most notable lack of criticism is the unusual nature of the last decade, in which interest rates sustained themselves around the world at generational low levels. To presume that foundation to be sound in the future (particularly when a pivot of global monetary restraint has already started), is to congratulate Lance Armstrong for his Tour de France wins without noting his use of illegal drugs.
T.I.N.A. (‘there is no alternative’) is no longer a present condition as 1-month, 3-month, 6-month and 1-year Treasury yields are now at their highest levels in 10 years:
There is now an alternative.”
“The magnitude of the market’s rise in the month of August is almost certainly borrowing from future returns. In the extreme, a more durable and significant top may be forming.”
Higher borrowing costs on the short-end reduces consumption and the demand for imported goods. Emerging markets are likely already signaling there is an issue from the Federal Reserve’s actions, and the consequence historically has not been good. But, as I quoted yesterday:
“Unfortunately, Powell left the unsettling feeling that monetary policy can be summarized as ‘We plan to keep hiking until something breaks.’” – Tim Duy
Just something to think about as you catch up on your weekend reading list.
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