by Bryan Perry
October 18, 2022
For the better part of 2022, the about-face and stampede to raise rates by the Federal Reserve has certainly put pressure on U.S. stocks, bonds, and housing, but more importantly, their actions are accelerating the chance of something “breaking” in foreign markets. The Fed is considered the global central bank that pretty much dictates how other central banks will shape monetary policy. They don’t have much choice.
It is this main focal point that will likely be the cause of that sound of something “snapping” overseas in the form of a major debt default by a large emerging market, a freezing of liquidity within the sovereign bond market, or some nonlinear forex price action in which a major currency just decouples under panic selling. Per a recent September statement out of the World Bank: “Rising global borrowing costs are heightening the risk of financial stress among the many emerging market and developing economies that over the past decade have accumulated debt at the fastest pace in more than half a century.”
Even as we see massive swings in British bonds, amid misguided policy steps by Prime Minister Liz Truss, forcing the Bank of England to intervene so as to afford a window for pension funds to unwind risky bets, its actions served as only a temporary shoring up of the pound’s free fall. This past week the pound started to roll over and may well revisit – or even take out – its September 28 low.
What’s to stop this same thing from happening with the dollar index, which tracks the dollar against a basket of advanced economy currencies, and is higher by 20% over the past year? Taking into account emerging market currencies, this move against them has been considerably more dramatic, both in terms of exchange rate and inflation. Much of emerging market debt has to be paid back in dollars and all oil transactions around the globe are conducted in dollars, still considered the world’s reserve currency.
If and when something breaks, it would likely be linked to a debt servicing crisis. A recent Allianz report concluded that “current debt-to-GDP ratios in France (113%), Italy (151%) and Spain (118%) imply a herculean fiscal consolidation effort to avoid an interest hangover” as debt-servicing costs explode higher. And Japan’s government debt is in worse shape, accounting for 231% of the country’s nominal GDP as of June 2022. Last Tuesday, the yen hit a new 24-year low against the dollar, down roughly 27% in 2022.
As troublesome as the weaker currency issues are in the UK, the EU, and Japan, it seems the biggest near-term risk of glass breaking overseas will be with emerging market debt. A systemic sell-off could be in the making, given the dollar’s rise, which intensifies debt levels in emerging markets. Without a policy change by the Fed to all but end the $95 billion per month QT program, it might just break open the dam.
Emerging market borrowing, led by China, inflated the global debt mountain to a record $303 trillion in 2021, although the global debt-to-GDP ratio improved as developed economies rebounded, according to the Institute of International Finance. The $10 trillion rise in the global debt pile was down from the $33 trillion increase in 2020, when COVID-19-related expenditures soared. But more than 80% of last year’s new debt burden came from emerging markets, where total debt is approaching $100 trillion, according to the Institute of International Finance (IIF), in its annual global debt monitor report (source: Reuters).
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
The most widely traded emerging market bond ETF is the iShares JP Morgan USD Emerging Markets Bond ETF (EMB) with about $13.8 billion in assets under management, trading roughly seven million shares a day. It is about as close a reflection of the health of the non-developed world debt market as one can monitor in terms of getting some kind of real time measure for the broad view of this asset class.
Because this is a managed fund, it doesn’t represent the gravity of the risk in the broader scope of the emerging market debt market, as China represents just 1.88% of its assets (ranked #22 on the list), and other highly leveraged countries are also smaller positions per this list of holdings:
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Mexico is its largest holding. Mexico is also the largest trading partner with the U.S., and so the fund is getting crushed, down 30% YTD, as both the dollar and interest rates rise to fend off inflation.
The chart of EMB (above) is flashing red and should be seen by the Federal Reserve as a market where it’s not a matter of “if” but “when” it breaks, because the biggest holders of emerging market debt are the banks of those countries issuing the debt, as well as a large amount held by European banks.
|United Arab Emirates||4.15%|
|British Virgin Islands||1.72%|
|Trinidad and Tobago||0.17%|
|The United States||0.14%|
All content above represents the opinion of Bryan Perry of Navellier & Associates, Inc.
Also In This Issue
A Look Ahead by Louis Navellier
Inflation Stays Stubbornly High, So the Fed Will Likely Stay Aggressive
Income Mail by Bryan Perry
The Fed Needs to Hear the Sound of Something Breaking
Growth Mail by Gary Alexander
Hurricane Season is Almost Over – In New Orleans and on Wall Street
Global Mail by Ivan Martchev
Where the $6 Trillion Came From
Sector Spotlight by Jason Bodner
But Seriously, Doc, How Bad is This Market?
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Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.
Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry
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