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By HaleStewart January 27, 2014 12:14 pm
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What the Heck is Happening In the Markets?

Starting at the end of last week, we’ve seen a large sell-off in emerging markets.  It started with Argentina devaluing their currency last Tuesday.  The South African rand has also sold off, as has the Turkish Lira – whose sell-off has been so sharp the Turkish central bank is calling an emergency meeting.  Not to be outdone, emerging market equity indexes have also sold off sharply.  So – why is this happening?  To explain that, we need to go back in time to the US Federal Reserve’s policies since the end of the recession.

When Fed started its asset purchase program, its intention was to drive done US yields.  Remember that bond prices and yields move inversely; in purchasing bonds the Fed was sending US yields lower.  As most interest rates are tied to the Treasury curve, this had the effect of lowering rates overall, with the hopes it would encourage borrowing. 

But this program had an ancillary effect; it forced investors to seek out higher rates of return.  This means that money left the US and flowed into emerging markets.  As a result, emerging markets experienced a net capital inflow that increased the values of their currencies and created a fair amount of economic growth.

At the same time, the Chinese growth miracle was starting to experience problems.  To overcome the effects of the great recession, China engaged in a massive stimulus program, leading to a huge increase in capital investment.  As the effects of this policy began to dwindle, the Chinese government realized it needed to change the composition of Chinese growth from one dominated by capital investment and exports to one dominated by consumer spending.  But, at the same time, local Chinese governments needed to keep up their respective growth numbers and, to do so, they borrowed heavily in the “shadow banking” sector.  Unfortunately, as the amount of debt in the Chinese economy increased, the rate of growth derived from each additional unit of debt decreased.  And finally, over the last 6-8 months, we’ve had two periods of spiking short-term Chinese interest rates as the Central Bank has tried to reign in the shadow banking sector.

Since the Chinese economy was already slowing down and experiencing some basic problems, traders were looking for a reason to liquidate their emerging market positions.  Last week, we has two economic numbers from China supporting a sale: a weaker than expected GDP number (7.7% YOY) and an ISM manufacturing number below 50, indicating a contraction in the manufacturing sector.  As a result of both numbers, traders have been selling emerging market assets, reasoning that since most of these economies export raw materials to China, their respective GDP numbers will decrease with China’s weaker than printed growth.

Right now, the selling is indiscriminate.  That will eventually change as traders separate the winners from the losers.  For example, most of Latin America and Emerging Asia are actually in decent economic shape, as both regions learned from their respective economic shortcomings.  For Asia, this was the 1998 Asian crisis and for Latin America it was the long-term effects of the 1980s and 1990s excesses.  However, there are currently issues of various types on India and Brazil (high inflation and low growth), Russia (low growth and lack of economic reform) the Ukraine (political issues) and Turkey (more political problems), so I would expect these countries to continue experiencing problems once the fallout subsides.  But, overall, most economies are actually in pretty good shape, so when this is over I would argue we’re looking at a buying opportunity.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer





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