The Independent Market Observer

1/24/14 – Be Careful: Turbulence Ahead in Emerging Markets

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jan 24, 2014 8:28:11 AM

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One of the themes of the past few posts (and of my market commentary in general over the last several months) has been the need for caution and a willingness to recognize—and plan for—risk factors.

One way to plan for them is to decide, ahead of time, what conditions would make you change your asset allocations—in this case, to dial back on risk—and then what conditions would make you reverse that again.

After yesterday’s discussion on market timing as a possible risk measurement tool, I’d planned to talk about its costs and risks, with a focus on how it could fail. I’m going to postpone that, however, as events have once again started to get interesting, in the sense of the Chinese curse “May you live in interesting times!” Drops in emerging market stock markets and currencies have become front-page news again, and they deserve to be.

The problem emerging markets now face is that, as the U.S. starts to pull back its stimulus programs, money will become more expensive and more scarce. Over the past decade, emerging market countries have borrowed extensively, just like the U.S. When times were good and interest rates low, lenders were happy to lend. To the extent that countries borrowed to invest in things that made their economies more productive—roads, factories, improved health and education—that investment allowed the loans to be paid. If, however, borrowing was used to finance consumption—housing, imports of consumer electronics and cars, and the like—well, the loan still had to be repaid, but the money had already been spent.

One of the consequences of the Federal Reserve’s taper in the U.S. has been a perception on the part of lenders that, relatively speaking, it’s now less desirable to lend to emerging markets than to developed markets, as the interest rate differential will become smaller. With that in mind, lenders are starting to pull back, and the emerging markets, accustomed to and dependent on growing financial flows, are now having to adjust. It’s easy to borrow but not as easy to pay back.

We’ve seen this movie before, in 1998 with emerging markets and more recently in the European Union (both cases where it was a real crisis), but this time shouldn’t be nearly as bad. Most of the emerging economies are now more open, with tradable currencies and foreign exchange reserves. Although the adjustment will still be painful, overall, it shouldn’t be catastrophic like last time.

Special cases like Argentina, which for a decade has been pursuing self-destructive but popular economic policies, should be the exception. Nonetheless, there’s no doubt that countries like Turkey and South Africa will have to adjust to living more within their means. This is part of what’s been driving political turbulence in these and other countries. There are certainly risks of a downward spiral—no one expected either the 1998 crisis or the European crisis to be nearly as bad as they were—but at this point, that doesn’t appear to be the most likely case.

What does this mean for the U.S.? Even if the adjustment process in other countries goes reasonably smoothly, it will cause lower growth there and much greater uncertainty. Markets hate uncertainty, and this will probably shake U.S. investors’ confidence—with a negative effect on the market. We’re seeing weak revenues and earnings for U.S. companies anyway, and the prospect of lower growth elsewhere in the world, especially in what have been the fastest-growing areas, raises more concern about future earnings. Overall, this is one of the external shocks to the market that I have identified as a risk in the past. If things do get worse than I now expect, the market consequences would be more severe.

While these events may rock the stock market, the overall effect on the U.S. economy could be more mixed, or even positive. If China slows down, for example, pretty much all commodities could become cheaper, which would help the U.S. economy. We’ve already seen U.S. interest rates drop over the past couple of days, showing once again the value of being the safe haven in an uncertain world. Lower rates should continue to support U.S. growth. Much of our growth, in any event, is domestically focused at this point. Slower foreign market growth will have a negative effect, but, in the overall scheme of things, could be relatively small.

This is a great example of why, despite being constructive on the U.S. economy, I remain cautious about the stock market. Current pricing simply has too many positive expectations baked into it, to the point that any surprises are likely to be negative. The problems in emerging markets may not be the surprise that derails the stock market, but even so, we’ll undoubtedly see more negative surprises through the rest of 2014.

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