The Edmond Sun

Business

September 21, 2013

THE ASTUTE INVESTOR: Beware of emerging market currencies

EDMOND — You know the old one-liner jokes that start with “You know you’re in trouble when … .” Now we can add one from the world of finance: You know you’re in trouble when the Greek stock market beats your stock market.

From the end of 2012 through the middle of August, all four BRIC countries (Brazil, Russia, India and China) could claim this dubious distinction. In U.S. dollar terms, Brazil’s stock market was down 29.9 percent, Russia’s market was down 14 percent, India’s market had fallen 21.4 percent and China’s market had dropped 7.1 percent.

During that same period, the Greek stock market posted a 1 percent return. The point here is all about the BRICs, the recent darlings of the investment world, and how they have fallen.

In large part, global consumption drove the incredible growth in these four countries — along with many others around the globe — during the past 15 years.  The thirst for energy and gadgets exploded during the late 1990s and early 2000s, giving raw material providers and cheap labor countries an incredible boost to their economies and their markets.

Yes, the 2008 financial crisis briefly hit these emerging countries, but then the central banks of the world took over. As they flooded the world with cheap capital, providers of raw materials and cheap labor got their second wind. It seemed for a couple of years, from 2009 through 2011, these countries would be able to take a pass on the fallout from the greatest financial upheaval since the 1930s. Until now.

The feeling was that a rise of economic activity in these young, developing nations could offset a drop in activity in the aging countries of the world. This view held for a while, but then reality hit. It turns out that, while these youthful economies do have legitimate domestic consumption and growth, most of their outsized gains are reliant on selling to those stodgy, old, Western economies (as well as Japan) that are now limping along.

Without the U.S., the European community and Japan buying more and more, the BRICs had to devise their own plan for creating growth, which typically involved extending a lot of credit on easy terms. We all know how this story ends — with lots of bad loans and questionable assets on bank books.

The last six months have been something of a wake-up call, with many previously high-flying countries that rely on exporting to either the EU or the U.S., or their suppliers pushed back on their heels. In U.S. dollar terms, South Korea is down more than 10 percent, Mexico has dropped more than 6 percent, and even Canada, which is not a young country but is definitely a raw materials supplier, has fallen by 3.6 percent in dollar terms.

As we move into the fall and turn the calendar to 2014, I expect this trend to continue. Economic activity in the U.S. is steady, although at a low level. There are no signs of a robust explosion to the upside. Likewise, Europe is not spiraling down, but it’s not on a soaring trajectory either. This leaves the BRIC economies and their compatriots to deal with growth internally, and now to deal with their own mini-credit bubbles and locally inflated asset prices.

In addition to taking a back seat to Greece when it comes to market returns, it is possible that one of these countries or a group of them could trigger the next global financial crisis. We are about to see one of the unintended consequences of quantitative easing and what happens when it unwinds.

As the Fed lowered interest rates to basically zero, the hot money went looking around the world for better returns. Money poured into emerging market countries looking for higher rates. This also drove their currencies higher and created challenges as to what to do with all the money. As is often the case, not all of it was deployed wisely.

We are now seeing a preview of what happens when it goes the other way. In the past few months, with just the hint that the Fed “might” begin tapering the amount of QE (bond buying), the hot money has been leaving emerging countries like rats leaving the ship. Currencies in India, Brazil, Indonesia and many others fell like a rock. Of course, the Fed says that is not their problem, but if it spirals out of control it will become our problem.

The same buyers who poured into these emerging market currencies are now quickly rushing out. This leaves developing countries with few options and all of them are bad. They could raise interest rates (attracting more carry trade buyers), but that would slow or choke their economic growth. They could buy their own currencies in bulk to prop up prices, but they’d deplete their currency reserves. Or they could do nothing (allowing the free market to figure it out), which likely would put emerging market currencies into a free fall and create high inflation. This is truly one of those “between a rock-and-a-hard-place” scenarios.

You see a positive feedback loop on the way in: Buyers bid up prices, higher prices entice more buyers, who further bid up prices. This quickly turns into a negative feedback loop on the way out: Something changes and spooks buyers, they sell, pushing down prices, which spooks other investors, who then sell in panic pushing prices down even further.

The global economy is teetering in a precarious position. All it will take is one major crisis to trigger a chain of events that spirals out of control. The collapse of emerging market currencies, much like what happened in 1997, could be it. You could call this being hit by a BRIC. Beware. The one positive consequence for us, as I’ve been saying for a while now, is a bullish outlook for the dollar. Thanks for reading.

NICK MASSEY is a financial adviser and president of Householder Group Financial Advisors in Edmond. Massey can be reached at www.nickmassey.com. Securities offered through Securities Service Network Inc., member FINRA/SIPC.

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