Rest Of The World Not Immune To Fragile Emerging Markets (EEM)

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September 18, 2018 6:32am NYSE:EEM

From Adem Tumerkan: I’ve enjoyed watching the mainstream financial media fumble over themselves trying to explain the Emerging Market crisis of 2018.

It’s even more comical watching them try and tell us that everything’s OK from here.

My opinion? Not even close.

So let’s go over some things. . .

Below is Goldman Sachs’ six-month moving average of the US and Emerging Market CAI (current activity indicators). And as it points out – Emerging Market growth has tanked since the beginning of 2018. Especially compared to the U.S.

Although there’s been a steep decline in Emerging Market growth, I don’t think that’s quiteenough to cause a complete panic in the Emerging Markets.

There’s more to it than simply growth under-performing. . .

You see, for many years after 2008 – courtesy of the Fed – the U.S. had some of the worlds lowest ‘real’ rates (adjusted for inflation).

This drove at least two things:

First – Hedge Funds, Banks, and ‘Shadow Banks’ engaged in huge ‘dollar carry trades’ (I go into ‘carry trade’ details and much more here).

And Second – Emerging Markets gorged on cheap dollar denominated debts.

Since institutions were starved for yield, they invested abroad in riskier Emerging Markets to get the extra one-or-two percentage points over U.S. bonds.

This lasted for years – but starting at the beginning of 2018, the U.S. inflation rate started picking up above the Fed’s 2% target.

This prompted the markets perception that the Fed would raise rates faster and possibly higherto combat this inflation dilemma.

So, there was an unwinding of ‘carry trades’ by the big banks. Emerging Markets had to pay higher interest payments on their dollar denominated debts. And investors sold their Emerging Market bonds an equities – as well as currencies – while rotating into U.S. bonds.

This caused a ‘reflexive’ dollar rally – which is fuel to the fire of the Emerging Market chaos.Just look at the currencies of Turkey and Argentina for example.

I’ve maintained for a while now that the Fed’s post-2008 ZIRP (zero interest rate policy) and money printing (QE) were making Emerging Markets extremely fragile. Especially once the monetary easing turned into tightening.

We’ve seen this story time and time again.

For instance, back in the 1990’s, then Fed chairman – Alan Greenspan – kept rates pretty low. And Emerging Markets (especially Asian countries) had huge inflows of U.S. dollars from investors in search of yield.

These countries became very fragile over time. They became dependent on cheap U.S. debt and easy access to investor capital.

But once rates started rising and investors took their money out of these countries – Emerging Markets and their currencies tumbled like dominoes – one by one.

This time was no different. Sooner or later, these Emerging Markets were going to feel the wrath of higher U.S. rates.

But will it end there?

Goldman Sachs is now also highlighting the growing fragility of the markets caused by rising U.S. rates (and Quantitative Tightening – QT).

And as the crowd keeps focus on the Emerging Markets – we need to look ahead.

What fragile thing is next in line to break?

Investors rushing into the U.S. feel safe – especially since U.S. growth has picked up recently.

But what if U.S. growth starts declining – or what if the U.S./China trade-war causes unintended consequences?

Puzzling many already is that even during the third year of the Fed’s tightening cycle – ‘risk premia’ (the return above the risk-free rate) across the board are at very low levels.

And the U.S. yield curve’s still flattening – nearing inversion.

There’s clearly something not right coming from the bond and risk markets.

So beware.

Remember the fable of the boiling frog?

If you put the frog into boiling water, it will jump out immediately. But if the frog’s put into slightlywarm water – it won’t sense the danger while you slowly bring it to a boil.

Just like the frog – many investors don’t feel the danger right now.

But it’s still there.

The iShares MSCI Emerging Markets Indx ETF (EEM) rose $0.28 (+0.67%) in premarket trading Tuesday. Year-to-date, EEM has declined -11.76%, versus a 8.86% 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 90 ETFs in the Emerging Markets Equities ETFs category.

This article is brought to you courtesy of Palisade Research.

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