Last year, the US S&P 500 index rose an impressive 19%. Other markets were just about as competitive. Japan’s Nikkei 225 Average was up about the same amount while Germany’s Xetra Dax climbed 13 per cent and the FTSE 100 rose 8 per cent. Emerging Market equities managed to beat the S&P handsomely.
In 2018, the S&P has so far done well again. It has come through a period of increased volatility, is retesting its January highs and has risen a healthy 6 per cent this year. Some of the US outperformance can be attributed to strong corporate earnings assisted by Trump-inspired corporate tax cuts. Earnings per share for the S&P 500 are expected to rise 20 per cent in 2018. But other markets have fallen by the wayside. The Nikkei, FTSE 100 and Dax have given up all their 2018 gains. Emerging Market equities are now down 20% from their peak and there is a risk of market contagion, not only across the whole EM sector, but across developed economies and markets themselves. Markets are very unsettled right now. So what is going on with Emerging Markets?
The Emerging Market sell-off has included parts of Asia, Turkey, South Africa, Brazil and Mexico. The most obvious catalyst for anxiety is the doubling since 2008 of dollar loans to Emerging Markets to $3.6 Trillion. As the US Dollar has moved into strengthening mode on the back of rising US interest rates and a strong economy, the cost of servicing that debt by EM countries rises. Argentina, Turkey and South Africa notably have large current account deficits to service.
Argentina’s government alone, spurred on by ultra-low interest rates, has borrowed about $80 Billion in two years to soften the social cost of reforms. Last year, the government sold $2.75 Billion of oversubscribed 100-year bonds. Argentina is not helped by the worst drought in three decades shrinking the country’s key agricultural sector by half. Tensions in the Middle East have also pushed up all oil prices, making Argentine energy imports more expensive.
Further afield, US protectionism has particularly hurt Asian countries, whose current account surpluses might otherwise protect them from rising interest rates. But the US threat of $200 Billion-worth of tariffs against China, and the perceived risk to global trade, has sent them into a spin too.
The fear is that contagion may set in, as losses in one market prompt investors to sell in others, generating a vicious spiral that could hit all markets, including richly-valued US equities. This is not quite a fully blown EM crisis yet…call it ‘an EM moment’ but it depends how various EM central banks and politicians respond. If handled poorly it could pose a threat to advanced economies.
The market fully expects another key ‘Fed Funds’ interest rate hike at the September FOMC (Federal Open Markets Committee) meeting and the odds for a fourth quarter-point rise for 2018 in December have firmed into the 70% range. The ‘Fed’ wishes to ‘normalise’ interest policy i.e. move away from the financial crisis required ultra-low interest rate regime.
The yield on the policy sensitive two-year Treasury yield hit a decade high above 2.7% last week. The yield on the closely followed 10-year US Treasury bond is currently 2.95% close to the ceiling of the broadly 2.5-3.0% 2018 range. This means that the US Treasury yield curve is very flat with only a 25 basis point (0.25%) differential between 2 and 10-year bonds. Such a flat yield curve normally implies investors do not think that interest rates, nor inflation, are going to rise too much in the foreseeable future.
Brent oil reached a two-month high this week of $79.72 on escalating Middle East tensions.
Gold remains fairly subdued at just over $1200 per ounce. Gold is seen as a ‘safe haven’ investment -it has been around for 5,000 years – but as a non-interest bearing asset it does not do well in a rising interest rate environment. Should the EM ‘moment’ develop into an EM ‘crisis’ the gold price will move up accordingly.
S&P 500: 2878
FTSE 100: 7277
Bonds – 10 Year Government Yields
EUR/USD 1.1580 (1 euro buys 1.1580 dollars)
GBP/USD 1.2900 (1 pound buys 1.2900 dollars)
OIL: Brent: 77.00 (dollars per barrel)
GOLD: 1205 (dollars per ounce)
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