Markets crashed today because the EM markets are crashing. An ETF for EM debt was down 3.26% and an EM equities index fund was down 2.65% and the SP is down 2.1% where it has gone below 1800.

The EM markets were overstimulated by excessive use of debt and excessive reliance on commodities. However commodity producing is often a very risky business prone to severe and unpredictable slumps that hurt businesses with high fixed plant and equipment such as mines and smelters that can’t simply be moved and sold off at auction. Thus they experience a deeper slump than a more nimble, less capital intensive service industry would.

The dominant paradigm of the past 20 years has been rapid growth of EM economies because of their alleged low cost, non-unionized, low (or flexible) bureaucracy, low tax environment. Now the EM countries have partly converged with Developed countries (partly because some Developed country wages and costs have declined) and acquired similar amounts of regulations, costs, higher wages, and lack of cheap resources so that EM countries are no longer such a great opportunity, thus their growth rate has slowed. However EM countries have more hidden business risk especially for foreign businesses and foreign lenders.

Argentina is falling apart, and is headed for a bond default. Their currency dropped from 4 to the dollar to 13 in the past 13 months, a 70% drop. On January 23 the peso dropped 10%. They had 7% GDP growth rate but it was done through severe inflation and now their economy is crashing and thus giving back the gains. When I was in Bolivia I met someone who told me the currency had an overnight devaluation that created massive losses for savers. There seems to be a pattern in EM countries of an artificially induced bubble that produces high growth and exports but which ultimately result in bond defaults, crashes and inflation. A default by Argentina will be a significant impact on EM debt which could create a panic movement out of EM bonds and into Developed country bonds, including Treasuries. As EM debt investors wake up and realize how risky that asset class is then EM countries will lose access to new funding and their economies will slow.

The WSJ ran an article 1-21-14 “The Emerging Market Comedown” saying EM growth was mostly due to confluence of commodities and excessive use of debt with problems from the middle income trap. I have been writing about this for over a year. I expect in future decades economists will look back at the 1990-2010 era as a misleading outlier where EM countries appeared to have superhuman growth rates but these rates were either an anomaly or were unsustainable for more than 20 years due to excessive, unsafe use of debt, plus one-time windfalls from commodities, which was exacerbated by China’s huge boom. Ultimately Developed country institutions such as sound currency, stable, reliable government, democracy, plenty of educated people, and reasonable use of debt with transparent honest financial statements that facilitate proper use of debt will create a faster, more sustainable, more stable growth rate than in EM countries. You can’t simply look at the price tag and assume the cheaper vendor wins. The value-add in corporate profitability is in the “design shop” section of a business located in Developed countries instead of the low wage commoditized manufacturing section that EM countries host.

Additionally an investment needs to be evaluated on a risk-adjusted basis such as one does with a Sharpe ratio. If the risks of an EM country including the commodity cycle are greater than Developed countries but EM ends up merely matching the return from Developed countries than EM investments will be less desirable than Developed countries.

The Developed world’s Central Bank Quantitative Easing caused capital to flee to EM bonds and stocks which resulted in a debt fueled boom in EM countries. This boom is ending. As investors wake up to the risks of EM debt then that source of funding will dry up creating a reduction of growth rates in EM countries which will affect Developed world sales, profits and stock prices.

Perhaps this EM crash will be the catalyst that makes investors in the SP realize that the SP is too expensive and needs to decline to 1160 to reach fair value.

Investors should seek independent financial advice about how to avoid stock market bubbles. I wrote an article “End of QE reveals weakness in global economy” and “EM crash implies dollar to keep rising”.

 

 

 

 

 

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