The term “emerging markets” covers a wide area.
Emerging markets, or economies, are all different, but they are generally differentiated from developed markets by quicker economic growth (from smaller per-capita bases), faster demographic growth (in some cases) and in better long-term returns with higher volatility.
The major equity benchmark index for the emerging market space is the MSCI Emerging Market Index, which is represented by the iShares MSCI Emerging Markets ETF EEM, +0.42% EEM had a good run (nearly doubling) from the January 2016 lows that were the climax of China hard-landing fears, to a January 2018 all-time high. It’s now down 12% since Jan. 26, and I think the MSCI Emerging Markets Index will fall back into its long-standing range and ultimately take out those January 2016 lows when the hard landing in China actually arrives. I believe that is a matter of “when,” not “if.” (See chart.)
The comparison of sovereign yields (see chart) and emerging-market currency performances (see chart) show that we are beginning to experience the “higher volatility” part of the emerging markets universe, which started in the currency and bond markets — where Turkey and Argentina are clear standouts since April — which will surely spill into the equity markets. I do think that China is the big unknown here as there are capital controls that are not very good, as it has lost $1 trillion out of its $4 trillion foreign exchange reserves at its peak between mid- 2014 to mid-2016, and those capital outflows have now resumed. (See chart.)
Three crises in 20 years
In 1997-1998, it was the Asian Crisis — ironically also driven by too much dollar borrowing — that spilled over into a Russian debt default due to the collapsing oil price, since that was the primary contributor to their federal budget. In 2008, we had the Great Financial Crisis that emanated in New York and was centered on various mortgage structures that were built on the fascinating strategy of manufacturing AAA-rated CDOs from subprime mortgages! A decade later, in 2018, we have the massive expansion of dollar borrowing in emerging economies that will result in a gigantic dollar short squeeze catalyzed by the Federal Reserve policy of quantitative tightening. (For more, see the St. Louis Fed report, “Global debt is rising, especially in emerging economies.”)
The U.S. Dollar Index DXY, -0.75% closed above 94 last week and has been over 95 this week on Italy worries. I think it is only a matter of time before it crosses 100, which very well may happen before the end of the year. Currency trends tend to build up pressure and then react violently in the direction of the fundamental trajectory of developments. In many respects, the 2017 decline in the dollar was driven by political events in the eurozone that will not be present in 2018. In fact, we have populist Euroskeptic parties trying to form a government in Italy, which is the reverse of the pro-EU election victories in 2017 that helped the euro recover. (For more, see my MarketWatch column, “Ivan Martchev’s 2018 predictions: Gold will sink, and the dollar will rally.”)
The issue in any financial crisis is that there are multiple factors reinforcing one another, which is how a crisis often gathers steam. We are at the early stages of an emerging markets crisis, which this time, again, is driven by rampant dollar borrowing. Not every emerging market will be affected the same way — with Russia and India being the more fiscally responsible examples — but I do think that China is the biggest unknown. Capital controls are helping for the time being, but as we saw in the Asian Crisis 20 years ago, capital controls work until they don’t. Near the end of the currently brewing emerging markets crisis, China may very well opt to devalue similar to the way it did in 1993 to the tune of 34%.
False sense of commodity security
At the onset of this dollar surge, we have seen very little spillover into commodity prices, as it has been only a month or so since the dollar turned notably upwards. I think that divergence will correct itself with the dollar being up a lot more and commodity prices reacting negatively, as they historically do, particularly when the selling in the currency and bond market spills over into the local economies as capital flight accelerates in places like Turkey, Argentina and China. (See chart.)
I am a little puzzled at the price of oil, where supply is plentiful, yet we saw the price appreciate in the seasonally weak September-March period. We are in the seasonally strong period for oil prices at the moment, but I doubt that oil can keep rallying — last week’s decline notwithstanding — with the dollar strength likely to accelerate, in my view.
An added factor may be the U.S. pulling out of the Iranian nuclear deal, combined with Israeli saber rattling. It is understandable that oil traders might be worried that any military escalation with Iran will put pressure on oil prices in the seasonally strong period of the year. Still, the Israelis have responded with air strikes and diplomatic shuttles to Moscow, the major power broker in Syria. The Russians have decided that the best course of action is to solidify their position in Syria and demand that only the Syrian Army is present on the Israeli and Jordanian borders, despite some remaining areas under ISIS control.
I think the Iranian factor in the price of oil has peaked for the time being, and with a lack of military confrontation with Iran, it’s the dollar and emerging markets pressures that will drive the price of oil. I don’t think the divergence of firm commodity prices and a surging dollar will continue for much longer.
Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates. The opinions expressed are his own.