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The Real Reason for International Declines

Written By Briton Ryle

Posted January 27, 2014

Map of Emerging Markets

What happens when you zoom in too close on something? You don’t get a clear picture amidst too much detail. Photos look like a bunch of dots, maps show just half a block worth of street, and stock market graphs display just a moment’s gyration.

That’s what traders and analysts did with last week’s market data. They zoomed in way too tightly – specifically on Thursday and Friday alone – and lost sight of the big picture.

On those two days, America’s S&P fell 2.98 percent, the U.K.’s FTSE fell 3.1 percent, Singapore’s FTSE fell 3.5 percent, Germany’s DAX fell 3.6 percent, France’s CAC fell 4.3 percent, South American indices fell between 4 and 5 percent, Hong Kong’s Hang Seng fell 5 percent, Tokyo’s Nikkei fell 6 percent, and China’s Shanghai Composite fell –no wait a minute– the Shanghai Composite rose a slight 0.5 percent. The world was reeling.

What was behind those terrible last two days of last week? “Activity in China’s manufacturing sector contracted in January for the first time in six months as new orders declined,” reported the Wall Street Journal, “confirming that a mild slowdown at the end of 2013 has continued into the new year.”

…Even though China rose.

“The recent economic data from China is pretty disappointing,” specified Timothy Ghriskey, chief investment officer at New York’s Solaris Group. “The weakness in China is a global concern and that’s why you see global markets being weak,” Ghriskey summarized. Even though China rose.

A concern, yes, for everyone else but China, it seemed. Though at the time of this writing early Monday morning, China’s Shanghai Composite is about 0.5 percent below Thursday’s open, it still is not nearly as negative as other markets were at the end of last week.

Why? There must be something else going on besides simply the recent data coming out of China that is taking down world markets, which are falling harder than China. To identify what it is we need to zoom out, way out, so we can get a clearer picture.

As we zoom out we will realize that there are two different pictures here – one for emerging markets, and one for developed markets. And neither one has anything to do with China.

Emerging Markets Are in Serious Trouble

“We haven’t seen anything like this since 1998,” exclaimed Michael Shaoul, CEO of Marketfield Asset Management, referring to last week’s currency routs in emerging markets around the world.

From Monday the 20th to Friday the 24th, the Indian rupee fell 1.9 percent, the South African rand fell 3.2 percent, the Brazilian real fell 4 percent, the Turkish lira fell 4.3 percent, and the Argentine peso fell 5.1 percent – all amid similar currency plunges across emerging markets.

Although many emerging economies do trade with China, the recent slowdown in China is not what’s behind these currency plunges. Zooming out a little further we see that emerging currencies have been falling for years. Among the five listed above, the rupee has fallen 29 percent since 2011, the real has fallen 36 percent since 2011, the lira has fallen 40 percent since 2010, the rand has fallen 41 percent since 2011, and the peso has fallen 57 percent since 2008.

What is happening to emerging markets around the world is that they have been haemorrhaging foreign investments since America and other western economies started recovering from their recent 2008-09 recessions.

Since the West has been growing progressively less risky with each passing year, money has been slowly exiting emerging markets toward western currencies and bonds – especially since mid-2011 when the U.S. 10-Year Treasury yield started rising again after hitting its all-time bottom.

The loss of foreign investments in emerging markets widens their current account deficits, causing their currencies to plummet. Emerging markets count on foreign investments to pay for their operations and fund their growth. Take those investments away and they are left to grow under their own power, which is simply not enough. Expansion slows, and growth deteriorates into recession.

When the west was hurting, emerging markets were the recipients of large sums of deposits, lifting their currencies to the moon. Now that the west isn’t hurting as much any more, the money is flowing back the other way – from emerging back to developed – and emerging markets are correcting back down.

This does not mean that it’s all over for emerging markets, as there are plenty of viable investment opportunities there. It simply means that now that the U.S. Federal Reserve has begun reducing its monthly stimulus, and will eventually begin to normalize interest rates over the next three or four years, the wave of investments is definitely flowing to the west.

Once the 10-Year note’s yield reached 3 percent on the commencement of Fed tapering last month, such rates were just too attractive for investors to resist – triggering the most recent currency plunges across emerging markets.

That’s why we need to zoom out and look at the broader picture. That broader picture tells us to trim our holdings in emerging markets for a while, possibly over the next two to three years as interest rates in the U.S. start to rise.

But that doesn’t mean abandoning them all together. Diversifying some 10 to 15 percent into emerging markets is always wise, especially since western markets look to be heading into a correction of their own. This is the second picture we see now that we have zoomed out.

The West Has Troubles of its Own

Yes, western stock indices tumbled late last week, triggered by China’s poor January manufacturing number. But once we zoom out, there too we see that there is something else going on behind the scenes.
Since recovering out of the 2009 global crisis, the S&P is up 160 percent, the DAX is up 140 percent, the Nikkei is up 115 percent, the FTSE is up 88 percent, the CAC is up 66 percent, and the Shanghai Composite is up … no, wait a minute … China’s Shanghai Composite is down 42 percent.

So what is going on here? Why does China’s Shanghai Composite keep moving against western markets, both when we zoom in on the week and zoom out over years? It’s all about stimulus and corrections.

While China’s economy was left by the Chinese government to correct on its own over the past five years since the 2008-09 global crisis, western economies have been propped up by one stimulus measure after another. Thus, China’s index is down while everyone else’s is up.

The latest poor data out of China is merely the latest down-point on a five year down trend, so the Shanghai Composite is simply taking it in stride, with no major reaction to it.

Western markets, on the other hand, have been running opposite to China’s markets for five years – and without a meaningful correction since 2011’s 18 percent drop some 2.5 years ago. With Treasuries providing healthy yields not seen in 3 years, it looks like it’s time for money to start flowing out of equities back into bonds – at least until equities have their 10 percent pull-back.

What’s Really Going On

So, then, if we are zoomed-in to the max, it might look as though the latest numbers out of China are being taken as an omen of another global slowdown around the corner, with markets around the world from developed to emerging reeling because of it.

But on pulling back to look at the broader picture over the last five years we see a different story. The China numbers are nothing new; the trend there is the same as it has been for five years.

What is really hurting world markets – from developed to emerging – is a more attractive western bond. Stable and higher yielding, western bonds have been stealing money from emerging markets since they started rising in 2011. And at their highest yields in 3 years, they are now starting to siphon money out of western stock markets as well.

It isn’t China at all. It’s the western bond that’s causing all the trouble. And that means two things are now upon us – a full-blown flight out of emerging markets, and the beginning of a healthy correction in developed markets.

Stay in bonds until the dust settles. When the upcoming equity correction is over, you’ll have some very nice bargains to choose from.

And keep an ear out for this week’s FOMC meeting scheduled for Tuesday and Wednesday. It just might be possible that the Fed will hold off on further tapering of its bond purchases. I even heard some calling for the Fed to raise bond purchasing back up.

If the upcoming correction is deep, don’t be surprised to see bond purchases to go back up to $85 billion or even $100 billion per month in March. That should stop the equity correction in its tracks, push bonds yields back down, and give emerging markets a temporary reprieve.

Joseph Cafariello