Friday, February 7, 2014

Emerging markets are crashing, reason to panic?

 The financial markets, in particularly the ones of Argentina and Turkey, are squeaking and creaking on all sides. The Argentinian government had to give up its support for the peso because dollar reserves were getting exhausted. Consequently, the peso took a nosedive. In Turkey, the same thing happened with the Turkish Lira. Other emerging markets also came under pressure, a sell-off wave hit India, China, Russia, South Africa, Brazil and other markets. What's the reason behind all this?

First of all, pretty much the same thing is happening what occurred in May of last year, when Fed chairman Ben Bernanke announced he'd soon begin the tapering process. So, fewer US dollars in circulation, which almost immediately created financing shortages in the countries with large trading deficits on their balance sheet. India, Brazil, Indonesia, South Africa and Turkey are the usual suspects. A tighter monetary policy usually leads to higher interest rates, which means countries with huge shortages are usually in trouble. Just like last May, a large capital outflow took place from those countries with weak currencies, especially now that the tapering is going to happen for sure. Argentina, South Africa and Turkey have already snapped, or are about to. The Turkish Lira fell by about 50 % before the financial authorities drastically had to intervene. In South Africa, Brazil and India, the interest rate was also raised in order to support their respective currency.

Secondly, the expected progress of the tapering of the Fed happens to coincide with an assumed slowdown in China. For some time, the economic data from China isn't as towering as we're used to. Now the figures of the purchasing managers were under 50, which indicates a contraction. To all that: add the anxiety that a 'Western like' credit crisis could break out in China after years of easy credit granting. Especially the shadow banking system has grown and strengthen significantly, making the banking system 'shaky' to say the least.

Unsettled economic climate

Both factors have a major impact in an environment where investors are already skittish about the equity markets. The stock markets rose to new all time highs recently, especially in the United States and Germany. In such an economic environment, every fact and detail is being thoroughly analyzed, and any negative figure can be a reason for traders to push the 'sell' button a little sooner than they normally would. A global decline in the markets, and a classic pull back to safety was bound to happen, with the biggest trigger being emerging markets.

The anxiety gets worse, due to the published results during earnings season. Some earnings from American and European (multinational) companies are disappointing, one of the main reasons: an expensive Euro, or an expensive US Dollar. Read: the currencies in the countries where they sell many of their products had fallen sharply. Apple (AAPL) is an example.

Is a repeat of the infamous Asian crisis (1997-1998) possible? Probably nothing of that magnitude. Nowadays, countries with huge shortages have large dollar reserves, so they can cover their shortages for some time. Sure, their currency and exchanges are under pressure, but their economies are now a lot better shape than they were back in those days. However, Argentina is an exception. The Argentinian economy was already performing poorly, and the current situation will only just push it over the edge.


Also things in China are probably not as bad as they initially seemed a few days ago. First of all, the purchasing managers index, which was reacted so heavily to in the past four years (41 % of the cases), has fallen under 50. Tell me something I don't know, nothing new there. And what about the credit crunch? Like I mentioned in my previous article, too much credit was extended to the people in China without much oversight (sounds familiar?). And yes, that is a problem for China. But keep in mind that this money is mainly used for speculative purposes. The participants of the Wealth Management Product (WMP) of Shanxi coal miner Zhenfu are bailed out, but the question remains if these practices will continue in the future. If this speculative bubble pops, then it shouldn't be that much of an issue for the economic growth. Better yet, the economy could become healthier. However, in the short term, it would somewhat have a negative impact. What we see today perhaps?

A point of concern for many western companies is the policy of the Chinese authorities, which makes it more difficult to sell (or produce) their products in China. Wages have risen sharply, the competition from China itself is sharply rising (Huawei, Lenovo) and regulations for foreign companies is stricter. As a result, Revlon has already withdrawn from China, L'Oreal is considering it, Walmart is closing some stores in China, and a number of other companies are looking for other opportunities. The golden years seem to be over for many western multinationals in China. The Chinese middle class is, as expected, in fact spending more, but they do not just buy western products.

Correction also creates opportunities

The turmoil in the emerging markets may last for some time and stocks could fall even further. The recent pullback in the markets is exactly as I expected, in fact, it's right on target. Nothing to worry about. At some point, this correction will offer traders and investors a wonderful opportunity. While everyone, rightly or wrongly, complains about high prices on the Western stock markets, the ones in the emerging markets have become significantly cheaper. The price-earnings ratio on the expected profit of 2014 of all emerging markets together is now 9. That is much lower than the price-earnings ratios in both Europe and the United States.

If investors aren't quite comfortable to directly invest in the emerging markets, then they can also choose to buy stocks from companies that realize a portion of their profits by operating in these same emerging markets. So, pretty much all large multinationals like McDonald's (MCD), Apple (AAPL), Unilever (UN), Daimler (DDAIF), etc.

The sharp decline in the currency of emerging market works both ways. Initially, it has a negative effect for those same multinationals. On the other hand, it makes exports from emerging markets significantly cheaper. Therefore it will be beneficial for the future profits of companies from emerging markets, which will have a price appreciation of the exchanges as a result.

The question now is whether or not the bottom has been reached, the benchmark stock index already sank to a five month low. I believe it's important to keep a close eye on the emerging markets since they play such an important role in the overall global economy, more so than they did five years ago. For that same reason, there's a good chance it will pick up again (historically speaking this happens every single time, check out chart below), to me it looks like we all have an opportunity to buy on a dip right very soon.

MSCI Emerging Markets Gross Dividend and MSCI All Country World Index Gross Dividend derived from Dimensional Fund Advisers.

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