The Emerging-Markets Meltdown

I wanted to talk a little about what’s been happening in the market recently. The Dow fell 176 points on Thursday and another 318 points on Friday. The real pain, however, has been in the emerging markets, and especially in their currency and bond divisions.

A lot of folks are blaming the Federal Reserve, and the winding down of QE (more on that in a bit). While our central bank is a convenient villain—and very often, the proper one—in this case, I don’t think they deserve the blame.

Let’s take a step back. When the financial crisis hit, the Fed and other central banks lowered interest rates to the floor. Econ 101: Money goes to where it’s treated best, so people started investing heavily in emerging markets where the yields (and risks) were higher. Investors particularly liked the so-called BRICs (Brazil, Russia, India and China). I’d throw South Africa into the mix as well.

The problem is that a lot of the emerging economies have some serious structural problems. The inflow of cash bought them time, but they haven’t done much to change their ways. Now that the Fed is talking about winding down its extraordinary measure, investors realize that near-0% interest won’t last much longer. Naturally, that will dry up the capital flow to the emerging markets. This problem is compounded by the fact that the governments in the emerging markets loaded up on dollar-dominated U.S. Treasury debt. As a perverse result, they’re doubly sensitive to moves in U.S. interest rates.

People knew this day would eventually come; they just didn’t know when. “When” is apparently now. The governments in the emerging markets are somewhat like a person who builds a balsa-wood house in a tornado zone. When the house goes to smash, they blame the poor foresight on the builder’s part, not the tornado.

The situation in Argentina is especially screwed up—although when I use the phrase “screwed up” in conjunction with our friends on the Rio Plata, it’s like saying there’s “trouble” in the Middle East. The president of Argentina didn’t make any public appearances for six weeks. Can you imagine if President Obama had done the same?

President Kirchner promised not to devalue the currency, but reality intervened. Of course this was after the government spent a pile of cash trying to defend the indefensible peso. In the last three years, Argentina’s currency reserves have been cut in half. No one really knows what the inflation rate or dollar-peso exchange rate truly is.

There are a lot of people in Argentina, in and out of government, whose job it is to see how well the economy is doing. They track all sorts of complicated econ data, but I have a simple rule I use: How loudly are the politicians yapping about the Falklands? If they’re loud, you can be sure that means the economy is a wreck.

I don’t want to pick on Argentina. Turkey is in bad shape as well. Brazil doesn’t look so hot, either. The one saving grace for a lot of EMs was their monster customer in China. But when we got sluggish economic reports from China, that really spooked EM investors. And oh yeah, there also appears to be a revolution going on in Ukraine. That, too, affects things.

It’s gotten so desperate that even the poor battered yen has done well. I’ll give you another easy rule: If your country exports a lot of commodities (especially to China), then your currency probably got whacked. Places like Turkey, Argentina and Venezuela are running very low on their forex reserves. Broadly speaking, I think currency devaluations can be the best of several bad options, but they don’t work all by themselves. You need reform, too, and that can be politically unpopular.

Quick tangent: One stock that I like to follow is Ingredion (INGR). They make high-fructose corn syrup. A lot of their operations are in Argentina, and last year, INGR cut its full-year forecast due to the government’s policies. The shares got hit hard on Thursday and Friday. By most superficial measures, the stock is cheap, but I’m not going near it. There are just too many unknowns.

Several years ago, Bill Gross of PIMCO made a daring investment when he loaded up on Brazilian bonds. That was a shrewd move, and it turned out to be a big winner. So it was a bit jarring when Gross recently said that Brazil is no longer attractive.

I don’t know where all these recent EM developments are headed, but we’re going to soon find out who’s been responsible and who hasn’t. Mexico, for example, will probably pull through just fine. Poland as well. But I’m not so sure about others. Until then, we can expect a little more volatility in our markets and a lot more in the emerging markets.

Posted by on January 27th, 2014 at 7:55 am

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