How The Emerging Market Crisis Could Affect The U.S. (EEM)

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September 10, 2018 6:22am NYSE:EEM

From John Rubino: This is the last emerging market crisis story for a while, promise. But one angle – exactly how a plunging currency in a far-off place affects supposedly stable markets like the US – is worth exploring because it’s happening right this minute.

Let’s start with the choices facing an American or European investor who needs a decent return, but who finds that interest rates have fallen to the point where traditionally safe things like bonds and bank accounts no longer yield enough.

Such an investor has two choices: 1) Stick with what they know and accept sub-par returns (which might mean being fired if you’re a pension fund manager, or – if you’re a retiree – having to spend your golden years as a Walmart greeter), or 2) Branch out into more exotic but higher-yielding instruments and hope for the best.

Option number 2 has been pushed by financial planners and pension advisors for the past few years, with emerging market securities being the exotica of choice. The sales pitch went something like this: Developing country stocks are cheaper relative to earnings and dividend yields than their rich country counterparts, while their bonds yield quite a bit – frequently two or three times – more than US Treasuries for only marginally more risk, so they’re a great way to diversify while goosing returns.

Many, many investors swallowed this and bought emerging market stock and bond funds. And for a while they reaped the promised high returns, allowing retirees to spend time with their grandkids and pension managers to keep cashing their massive paychecks.

Then – in part because of all the hot money flowing in from credulous First World investors – the emerging market countries started to veer off course. They borrowed trillions of US dollars and, when the dollar started rising against their domestic currencies, went into tail-spins of varying severity. And now tens of thousands of American investors who couldn’t settle for 1% returns are looking at double-digit losses.

Here’s a chart from Saturday’s Wall Street Journal featuring the Tennessee public sector retirement system, which made (in retrospect) a really excessive bet on emerging market ETFs. Note the great early-2018 results followed by a sickening plunge.

Tennessee pension returns

And here’s a chart showing the Tennessee system’s exposure to various emerging market countries, as a percentage of its total EM exposure.

Tennessee pension EM exposure

To its credit, Tennessee focused on the cream of the emerging market crop so presumably isn’t too exposed to Argentina or Turkey. Even so, its biggest holding, South Korea, is down about 10% so far this year.

Korea stocks Tennessee

The impact of these sudden losses on normally risk-averse investors? It scares them, obviously, making them even more cautious. Pension funds start shedding risk (which in this market means dumping tech stocks and foreign instruments of all kinds) and individuals try to shore up their nest eggs by spending less and saving more. It’s “risk off” all the way down, and the economy starts slowing.

And that’s the best-case scenario. A system as leveraged as today’s developed world might not tolerate even a mild deceleration, so pretty much any deviation from steady growth is potentially destabilizing. Which means volatility might be the only safe bet in the year ahead, and a return to QE thereafter.

The iShares MSCI Emerging Markets Indx ETF (EEM) rose $0.01 (+0.02%) in premarket trading Monday. Year-to-date, EEM has declined -11.82%, versus a 8.20% rise in the benchmark S&P 500 index during the same period.

EEM currently has an ETF Daily News SMART Grade of B (Buy), and is ranked #9 of 89 ETFs in the Emerging Markets Equities ETFs category.

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