Can the wisdom of a children’s tale, passed down through the ages, predict what lies ahead for investors in today’s emerging and frontier markets?
If one were to make comparisons between the worlds of global finance and fashion, then today’s emerging markets would be correlated with ‘Members Only’ jackets and the mullet. Ten years ago developing economies were the asset class du jour. Led by the iconic classification known as the BRICs (Brazil, Russia, India and China), the previous decade saw dramatic expansion of those four countries – over the course of that decade, their share of global GDP surged from eight to 19 percent.
In less hyperbolic times, the reputation gained after such a massive growth spurt could have been secured for decades. Unfortunately, in a media landscape dominated by 140-character press releases, hyperbole sells and world-beating growth is a disaster if it’s not as high as it was a year ago.
Like Icarus, Emerging Markets Have Fallen Far and Fast
Emerging markets (EMs) are undoubtedly facing serious headwinds right now, particularly those countries that have relied on commodity exports to fuel their economies for the past few years. Many companies in countries such as Brazil, Kazakhstan and Mongolia issued enormous amounts of dollar-denominated debt because (at the time) it was inexpensive. Today those issuers are being squeezed by the double burdens of contracting demand for their exports, and the general weakening of EM currencies across the board. Meanwhile, the credit ratings agencies are handing out sovereign and corporate downgrades faster than Disney is selling tickets for the upcoming Star Wars film.
I’ve always found it a bit hypocritical when Western economists complain about falling demand and a potential ‘hard landing’ in China. Here is a country with 1.4 billion people, whose economy just expanded by 6.9 percent in the third quarter – and yet the Western financial press reported those numbers as if the zombie apocalypse had just been unleashed:
“China GDP growth slides to 6.9%, worst since 2009” – Japan Times
“Asian shares trade lower on weak Chinese growth data” – BBC News
Here is a quick comparison of reported second-quarter GDP growth, with current estimates for the third quarter – which, for the US, will be published during next week’s Fed meeting:
What Happens If The Fed Hawks Stay In The Nest?
Which brings me to the other major issue that has our financial media outlets preoccupied these days – the (supposedly) imminent end of the near-zero policy and a gradual introduction of US interest rate rises. Such moves, it is widely assumed, will be the final nail in the coffin for emerging markets as the resultant surge in dollar strength pushes developing economies over the cliff.
In fact, this (supposedly) foregone conclusion is the primary reason that emerging market assets are so reviled in the markets today. The total amount of capital that has fled these countries is eye-popping; Capital Economics estimates that US$ 260 billion fled EMs in the third-quarter alone. No one wants to be standing on the beach when the tsunami hits.
But last month the conventional wisdom was disappointed when the Fed chose not to raise rates during its September meeting, citing market volatility and global instability. (The irony of our current situation – that much of this instability can be attributed to years of artificially low interest rates – was likely lost on the Fed’s Board of Governors). Increasingly, some market forecasters are now expecting rates to hold steady through the end of December.
But here’s the thing – and I am more confident in this than ever.
I am now convinced that the Fed will not raise rates until 2017.
We can look forward to another fourteen months – at least – of ultra-low rates and rampant debt issuance in the US. And of course, the unintended consequence of that policy is a search for more yield and further investment allocation into riskier asset classes such as high-yield debt, venture capital – and yes, emerging and frontier markets.
If I’m right, and the Fed doesn’t raise rates, then what happens to assets in emerging markets? Stocks in markets like Brazil and Turkey are absolutely hated right now. Strong companies like Turkey’s Akbank and Russia’s Gazprom have sold off as much as 40 percent this year, despite solid balance sheets.
But we’ll come back to that in a moment…
The Chairwoman Who Cried Wolf
You are undoubtedly familiar with the story of ‘The Boy Who Cried Wolf’. The tale is one of Aesop’s Fables, a group of children’s stories believed to date as far back as ancient Greece and first published in the 15th century. The legend is that of a shepherd’s boy who repeatedly tricks his townsfolk into thinking that a wolf is attacking his flock of sheep. The foolish boy continues to play the trick until the townsfolk, tired of his antics, ignore him. Of course, it’s at that point that a wolf actually appears and treats itself to a lamb smorgasbord, and the boy’s cries are to no avail.
Like many of wise old Aesop’s stories, this one bears an uncanny similarity to contemporary events. Take, for instance, Fed Chairwoman Janet Yellen’s repeated assertions that the Fed is likely to raise rates this year (as she stated in March, July and September). Her central claim is that inflation pressures are gradually going to rise, and thus action must be taken now.
Except that no action is ever taken. Instead of listening to the Chairwoman, I find that my views on Fed policy are more in line with those of Tom Piersanti, a New York options trader. His assessment of Yellen’s true outlook is exquisite:
“There will not be a rate hike until 2017. No way will they do it until the election…It’s more than likely the Fed believes the economy now “needs stock market wealth profits much more than usual, given the slowdown in global demand for commodities and exports…”
When asked how that can be the case when Yellen has told us differently, Piersanti says:
“Look again. Consider Yellen’s physical collapse — due apparently to temporary dehydration [during a speech in Massachusetts last month]. Maybe she pulled muscles laughing at [her own] speech! ‘Hey guys, wait until you hear this: ‘The majority of governors see a rate hike by year end — we really mean it this time!’ Then she spit her lunch out and pulled a muscle.”
I will acknowledge that it’s possible (though unlikely) that the Fed may just introduce a token 25 basis point rate rise sometime in early 2016, if for no other reason than to perpetuate the illusion that they are actually in control – and, of course, to prove contrarians like me wrong. But a sustained rate rise will not happen. Full stop.
Here’s why…and it has nothing to do with protecting emerging markets or the ‘global economy’:
The Fed’s FOMC (Federal Open Market Committee) will only meet two more times this year. The first occasion will be next week, on 27-28 October, which is a ‘minor’ meeting with no scheduled press conference. There is no meeting in November, meaning that the next meeting takes place in December 2015. Barring a truly extraordinary rise in inflation, a December rate rise is nearly unprecedented. This last happened in 2005, and that was in a year when the Fed raised rates five times.
The next FOMC meeting will not take place until late January, just before the Iowa caucus. This is the event that officially kicks off the US election cycle (as opposed to the past two years of excruciating media commentary and reality TV that we Americans have been subjected to).
Here’s the key point: the Fed is not going to raise rates during an election year. There, I said it.
Yes, I can hear you out there. “But the Fed is a non-partisan organization!” you protest. “Surely you can’t be so cynical!” you cry.
Indeed, I can. But it’s a learned behavior, based on years of experience of living and working in Washington DC.
Most of today’s sitting FOMC members, to include Janet Yellen, are Democrats – even if they take pains to avoid any perceptions of partisanship. One, Lael Brainerd, actually worked for the Obama White House as a political appointee to the Treasury Department before joining the Fed last year. And part of the FOMC’s charter includes a permanent seat for the New York Fed, which is a perennial Democratic stronghold. A rate rise, as we saw in last year’s ‘taper tantrum’, will spell disaster for US markets, push up borrowing rates for small businesses (for whom traditional bank lending has become nearly inaccessible) and kick-start another wave of defaults in the already over-levered mortgage market.
Hillary Clinton, the leading Democratic candidate, suddenly isn’t facing the runaway victory she thought she could enjoy. A market meltdown before July could level the playing field in favor of Bernie Sanders, who apparently wants to burn down any American bank with more than 50 employees. And even if she wins the Democratic nomination, the outcry from the voting public over a rate rise could provide a significant boost to the Republicans. We all might have to get used to saying ‘President’ and ‘Trump’ in the same sentence if that happens.
It is amidst this illusion of a looming Fed rate hike that emerging market assets have become the most-maligned asset class on trading floors everywhere. Traders hate EM assets more than they hate Elizabeth Warren, which is saying something.
But what if the talking heads are wrong? If political realities and presidential election calculus preclude a rate rise in 2016, then what happens to the emerging markets?
What if those predicting a rate hike continue to be wrong for the next year, as US economic figures continue to worsen? The most recent employment numbers were hardly grounds for optimism. We have already established that the primary reason that investors are avoiding emerging markets is because a Fed rate rise is imminent. But, if that decision never materializes, and the market gradually concludes that a rise will not be forthcoming until after the 2016 US elections, we may soon see a substantial emerging markets rally.
A third possibility, of course, is that the US economy enters another financial crisis next year. The 2008 election was arguably decided by the Global Financial Crisis. (And Sarah Palin’s involvement, but I digress). What happens if, between now and November 2016, the US economy craters under the burdens of $17 trillion in debt and a hollowed-out economy? You might think that there won’t be a safe place to turn anywhere.
It’s when I hear comments like this, that I am reminded of a trip I took to Sri Lanka last year. While in Colombo I visited the local stock exchange and reviewed some of their market data. I was particularly intrigued by the performance of the country’s Total Stock Market Index in 2009 and 2010:
That’s right, in that time period – when the entire world was falling apart – the Sri Lankan equity market index outperformed the Dow Jones Industrials Index by 455 percent. The moral of the story: there’s always a bull market somewhere. I’m sure that Aesop had a fable that speaks largely to that effect.
Finding an opportunity with the magnitude of Sri Lanka circa 2009, when the nascent equity market went stratospheric as a brutal decades-long civil war reached its end, is neither easy nor likely. But there are plenty of opportunities in emerging markets that are more easily accessible, if you care to look. And increasingly, the lower correlation with highly-inflated asset prices in Western markets should be seen as a positive.
And the moral to this story is thus: if you’re worried about the Fed’s ability to continue to control and manage global markets, or the as-yet unintended consequences of QE – and you should be – then you should start looking for safe ports of call before the hurricane hits.