Emerging markets

Posted By Darren Winters on Nov 9, 2019

Emerging markets

Have emerging markets hit the bottom which is typically a good time to buy?

The MSCI Emerging Market Index chart illustrates a recovery story, despite the narrative of a slowing global economy and hence the need for the central banks around the world to implement accommodating monetary policy.

Emerging markets bottomed out in mid-August crashing below its 980 floor and has since then made a steep recovery to above 1,040 near its resistance level

So the performance of emerging markets closely tracks the direction of the Fed’s monetary policy.

Developed markets are also sensitive to the Fed’s monetary policy, but emerging markets are more interest rate elastic.

When the Fed raised its fed funds rate to 2.5% in December 2018 global stocks got hammered, but even more so emerging market stocks and particularly emerging market currencies.

Emerging markets and dollar-denominated debts go hand in hand

US denominated debt of non-bank borrowers reached $11.5 trillion in March 2018, which was the highest recorded total in the 55 years. A large bulk of the world’s US dollar-denominated debt has been made to emerging markets.

Why are dollar-denominated debts a problem for Emerging markets?

When the Fed, the world’s central bank by default, tightens its monetary policy by raising the Fed fund rates it increases the cost of servicing this massive $11.5 trillion of global debt.

The Fed’s monetary tightening results in the US dollar appreciating on the foreign exchange. 

A strong dollar is burdensome for emerging markets with dollar-denominated debts.

Emerging markets find it more challenging to service dollar-denominated debts when the dollar goes up and the income they are earning is in their local soft currency

Emerging markets

In other words, a five percent appreciation in the US dollar makes serving a US dollar-denominated loan five percent more expensive.

So emerging markets alleviate the problem of a lack of US dollar liquidity by simply printing more of their local currency so that they can buy more US dollars which they need to service the interest on their loans.

But creating more of a local currency to service the interest payments on a US dollar-denominated loans is a short term fix for emerging markets.

In most cases when emerging markets create more of their currency out of thin air to service US dollar-debts, it often results in dire consequences

As emerging markets flood the foreign exchange market with more of their fiat currencies to service the US-denominated debt that also tends to depreciate their local currencies.

Emerging markets then double down by printing even more of their currencies which depreciates their currencies even further. So a downward spiral can result, with the end game looking like  a full-blown monetary crisis in emerging markets. The above scenario explains the peso crisis in 94, the Russian debt default in 98 and the Argentine collapse of 2001.

The Fed’s rate cut trio and 60 billion US dollars of asset purchases per month mean that the US dollar is likely to soften. So a weaker US dollar means emerging markets with have more liquidity as dollar-debts become less expensive to service in their currencies.

Emerging market’s recovery since August might not be fake, assuming the US dollar weakens

“They are two thirds on the way to hitting bottom,” said hedge fund titan Ray Dalio in the second half of 2019.

Could Emerging markets benefit from a temporary pause in US/China trade tension?

The current narrative is that worldwide economic slowdown has been triggered by US-China trade frictions.

But a casual perusal of the latest Panama transit statistics shows that the US-China trade war has yet to have any real impact on global trade despite all the mainstream media hot air that the central bank’s monetary accommodating policy is needed to counteract the US-China trade war.

Traffic between Asia and the East Coast of the US only very slightly decreased in tonnage (-2%) but it strongly increased in PC/UMS (Panama Canal/Universal Measurement System), a measure of volume equivalent to 100ft³ (+18.1%).

The Panama Canal, an artificial 82 km (51 mi) waterway in Panama that connects the Atlantic Ocean with the Pacific Ocean plays a major role in global shipping. The Panama Canal’s latest transit listing provides a good heads up regarding the state of globalization and global trade.

Moreover, the Baltic Dry Index (BDI) up 16.47% reaching 1697, which is well above its 52 week low is another bullish indicator for emerging markets.

BDI is a shipping and trade index created by the London-based Baltic Exchange. It measures changes in the cost of transporting various raw materials, such as coal and steel. A high BDI reading suggests buoyant demand for sea freight.  A BDI reading can help traders/investors gauge the state of the global economy, bearing in mind that most goods are shipped by sea.

The inverted yield curve is no longer inverted, so is the recession off and risk back on in emerging markets?

But the inverted 2s10s yield curve has been fixed due to the Fed’s decision to resume QE and target short maturity treasuries. So perhaps investors shouldn’t read too much into the inverted yield curve no longer being inverted.

Even the VIX Index or the volatility index has fallen asleep and fears nothing, so is it risk on and will there be a rotation of capital from value into growth stocks and emerging markets?

The VIX Index is near its all-year low 12.65, which suggests no fear in these markets.

So all is just fine for risk and emerging market assets, or is it?

We are approaching a seasonally good time for the markets as the year draws to a close.

The Santa Claus rally has yielded positive returns in 34 of the past 45 holiday seasons.

But equally, when stocks and other risky assets such as emerging markets fell in December they also tended to fall with momentum.

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