Emerging Markets: The Real Pain Has Yet To Appear

Because the tech sector has been dropping, investors are diversifying into the emerging markets. When I saw various news outlets reporting that, I could not understand how the rationale was made. Currency rates in these economies are dropping to levels not seen in many years if they've been this low ever. Stock markets in emerging markets are down 50% from their peak. Debt levels are at percentages far in excess of some of the world's most developed nations and are considered unsustainable. With interest rates in the United States heading higher, the moves that have already occurred will continue and apply even more pressure on emerging markets. I see the emerging markets as an opportunity; however, I see the opportunity to short the emerging economies. I am short the iShares MSCI Emerging Market ETF (EEM) and am looking for a substantial move lower over the course of the next year.

Here is a look at the chart over the past several years:

If you have been trading long enough, perhaps you remember in 1998 when the Asian Financial Crisis happened. I remember this all too well. The Thai baht was being supported by the government via a peg to the dollar. Due to many factors, the government could no longer support the baht and the currency was left to float. It collapsed, and so did the economy. From that, several other countries around that region saw their economies drop precipitously.

Without going into too much detail, there were many factors that brought about this particular financial crisis. In the United States, the US economy had been in recession at the end of 1992. The Federal Reserve pushed interest rates down to very low levels. Because of that and with world economies newly opening up to world trade, money left the United States in search for higher yields. Asia was one of the destinations. Here is a look at short-term interest rates in the United States that led up to the crisis:

The Asian Tigers, as they were so named, binged heavily on debt denominated in US dollars. The countries built infrastructure projects, businesses expanded, and the economies grew rapidly. However, eventually, the money started to leave these countries as interest rates started moving higher in the US. The US economy started its boom while the Asian economies started to slow down.

As money left those countries, the respective currency exchange rates started to move lower. The debt that these countries borrowed was denominated in US dollars. So, as money left those countries, it drug down the respective currency rates. This made repaying debt more difficult for the borrowers. This also started a cascade effect as money became "afraid" and left the country in fear that the debts would not be paid off. Eventually, it was total capitulation.

Sound familiar? The same scenario is playing out right now in China, Brazil, Argentina, Russia, and to a lesser extent, India.

Interest rates in the United States are heading higher. There are two factors that are affecting interest rates right now: the Federal Reserve and the Federal government.

The Fed is pushing up interest rates in response to inflationary concerns. After sitting at such low growth levels for a few years, the United States economy is expanding at high levels of growth: GDP growth is now at 3.5%, down from 4.2% previously. Inflation is starting to pick up and so the Fed is moving interest rates higher.

At the same time, the bank is letting bonds purchased from its quantitative easing programs expire. The effect of this is that interest rates over a more broad landscape are moving higher. This is attracting investors and money is repatriating back to the country where yields and risk levels are more attractive.

Then there is the Federal government which has an increasing deficit rate, adding debt to the overall debt at rates not seen since the financial crisis. This is weighing on interest rates as price continues lower in search of buyers. Because interest rates are rising, compared to previously near-zero levels, money is repatriating back to the United States.

The effect of this is the US dollar is moving higher, lowering currency rates against its respective trade partners. Several currencies, specifically emerging markets, are being weighed upon significantly, as the Chinese yuan and Brazilian real charts show below:

When you consider that in the 1990s, short-term interest rates went down to just 3% and moved up to 6%, this move was far more muted than the starting point we are at now. Interest rates were extremely low over the past few years hitting near-zero levels and are now moving up to more moderate levels. When I consider how the next move plays out, I keep the depth of the interest rate moves in my mind. The relative levels make me wonder that since so much money left the country due to such low levels, now that interest rates are heading higher, is it possible that the currency moves and other factors will be more exaggerated, thereby rocking the respective economies even more so?

Take China, for instance; they now have the highest debt-to-GDP in the world. In 2008, China's total debt to GDP was 141%. In 2017, it was estimated to be 256%. The country binged on credit throughout the past couple of decades helping to drive the world economies. Now, the country has been addressing its debt levels and the government is taking steps to reign in borrowing. However, the effects of this are slower growth rates for the economy.

Also, take another look at the chart above on the Chinese yuan: It is being pressured below levels not seen in many years. And, the stock market peaked in 2015 at some 5,200 but is now 50% that value, as this chart shows:

No two economies are the same. But, when you start to compare the economies of 1998 and today's emerging economies, you see a lot of parallels. So, when I read several articles printed in one day that tell highlight how investors are leaving the US tech sector because of high risk and low returns, and are investing their money in the world's emerging economies, I question the rationale.

In some regards, there are economies around the world that are already collapsing; Turkey and Argentina to name two. The respective currency moves have already been massive. These countries may have seen the bigger moves in their respective currency and debt instruments.

Given that, the fundamentals of each respective economy do not look favorable to me. If the fundamentals of a nation look dire, I don't see how the fundamentals of a particular stock would fare better. So, when you start to pick apart the iShares MSCI Emerging Market ETF and you see that some 45% of the ETF is in the regions that look the most economically fragile, it causes you to pause.

A lot of the companies within this emerging market index I would say are at serious risk of decline simply because of currency moves as well as overburdening debt loads, specifically Chinese companies. All of this sounds eerily familiar to 1998.

I am short the MSCI ETF. I have been shorting the ETF for just a couple of months as the US 10-year government bond interest rate moved above 3.00% and stayed there. This is the first building block of what may turn into a full-blown crisis in many parts of the world; some of these countries already are in crisis.

However, despite the fact that I see China being in economic danger - along with other emerging economies, the Chinese government is addressing the debt concerns. At the same time, the Chinese government has a huge war chest of reserves to dip into should they need to prop up their economy. There may be multiple factors you could argue that would say the Chinese will miss a full-blown crisis.

And, interest rates in the United States had already gone down to ultra-low levels and then back up again, as the 2002-2008 economy showed. There was no economic meltdown then, so perhaps the world economies may miss that type of event again. At the same time, currency levels are at very low levels so an argument could be made that any investment in emerging markets is being done at ultra-low bargain prices already.

However, I just see the stars lining up in different ways now. I see this as being a repeat of what the markets have already seen some 30 years ago.

I have been shorting the iShares Emerging Market ETF on-and-off over the past few months. It has worked out so far. From where I am sitting, I see potential with each respective economy to move lower significantly. I am going to continue to short this ETF looking for a substantial move lower. I just see everything lining up to repeat itself all over again.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

6 months conditional positive

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