May 30, 2018

The term “emerging markets” covers a rather large generalization. They are all different, but they are generally differentiated from developed markets by faster economic growth (from smaller per capita bases), faster demographic growth (in some cases), and in better long-term returns with higher volatility.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary

The major equity benchmark index for the emerging market space is the MSCI Emerging Market Index which is represented by the iShares MSCI Emerging Markets ETF (EEM). EEM had a good run (nearly doubling) from the January 2016 lows that were the climax of China hard landing fears, to a January 2018 all-time high. For all intents and purposes, I think the MSCI Emerging Markets Index will fall back into its long-standing range and ultimately take out those January 2016 “China hard landing” lows when the hard landing in China actually arrives. I believe that is a matter of “when,” not “if.”

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The comparison of sovereign yields (above) and emerging-market currency performances (below) show that we are beginning to experience the “higher volatility” part of the emerging markets universe, which started in the currency and bond markets – where Turkey and Argentina are clear standouts since April – which will surely spill into the equity markets. I do think that China is the big unknown here as there are capital controls which are not very good, as it has lost $1 trillion out of its $4 trillion foreign exchange reserves at its peak between mid- 2014 to mid-2016, and those capital outflows have now resumed.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In 1997-1998, it was the Asian Crisis that spilled over into a Russian debt default due to the collapsing oil price, since that was the primary contributor to their federal budget. In 2008, we had the Great Financial Crisis that emanated in New York and was centered on various mortgage structures that were built on the fascinating strategy of manufacturing AAA-rated CDOs from subprime mortgages! A decade later, in 2018, we have the massive expansion of dollar borrowing in emerging economies that will result in a gigantic synthetic dollar short squeeze catalyzed by the Federal reserve policy of quantitative tightening. (For more, see the St. Louis Fed report, “Global Debt Is Rising, Especially in Emerging Economies.”)

The U.S. Dollar Index closed above 94 last week and I think it is only a matter of time before it crosses 100, which may happen well before the end of the year. Currency trends tend to build up pressure and then react violently in the direction of the fundamental trajectory of developments. In many respects, the 2017 decline in the dollar was driven by political events in the eurozone that will not be present in 2018. In fact, we have populist Eurosceptic parties forming a government in Italy, which is the reverse of the pro-EU election victories in 2017 that helped the euro recover. (For more, see my Marketwatch column, “Ivan Martchev’s 2018 predictions: Gold will sink, and the dollar will rally.”)

The issue in any financial crisis is that there are multiple factors reinforcing each other, which is how a crisis often gathers steam. We are at the very early stages of the present emerging markets crisis, which this time is driven by rampant dollar borrowing. Not every emerging market will be affected the same way – with Russia and India being the more fiscally responsible examples – but I do think that China is the biggest unknown. Capital controls help for the time being, but as we saw in the Asian Crisis 20 years ago, capital controls work until they don’t. Near the end of the currently brewing emerging markets crisis, China may very well opt to devalue similar to the way it did in 1993 to the tune of 34%.

A False Sense of Commodity Security

At the onset of this dollar surge, we have seen very little spillover into commodity prices as it has been only a month or so since the dollar turned notably upwards. I think that divergence will correct itself with the dollar being up a lot more and the commodity prices reacting negatively, as they historically do, particularly when the selling in the currency and bond market spills over into the local economies as capital flight accelerates in places like Turkey, Argentina, and China.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I am a little puzzled at the price of oil, where supply is plentiful, yet we saw the price appreciate in the seasonally weak September-March period. We are in the seasonally strong period for oil prices at the moment, but I doubt that oil can keep rallying with the dollar strength likely to accelerate, in my view.

An added factor may be the pull out of the Iranian nuclear deal by the U.S., combined with Israeli saber rattling. It is understandable that oil traders might be worried that any military escalation with Iran will put pressure on oil prices in the seasonally strong period of the year. Still, the Israelis have responded with air strikes and diplomatic shuttles to Moscow, the major power broker in Syria. The Russians have decided that the best course of action is to solidify their position in Syria and demand that only the Syrian Army is present on the Israeli and Jordanian borders, despite some remaining areas under ISIS control.

I think the Iranian factor in the price of oil has peaked for the time being and with a lack of military confrontation with Iran, it’s the dollar and emerging markets pressures that will drive the price of oil. I don’t think the divergence of firm commodity prices and a surging dollar will continue for much longer.

About The Author

Ivan Martchev

Ivan Martchev is an investment strategist with Navellier.  Previously, Ivan served as editorial director at InvestorPlace Media. Ivan was editor of Louis Rukeyser’s Mutual Funds and associate editor of Personal Finance. Ivan is also co-author of The Silk Road to Riches (Financial Times Press). The book provided analysis of geopolitical issues and investment strategy in natural resources and emerging markets with an emphasis on Asia. The book also correctly predicted the collapse in the U.S. real estate market, the rise of precious metals, and the resulting increased investor interest in emerging markets. Ivan’s commentaries have been published by MSNBC, The Motley Fool, MarketWatch, and others. *All content of “Global Mail” represents the opinion of Ivan Martchev*


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