RISK #2: EMERGING MARKET FX DISRUPTIONS


Plunging emerging market currencies should not come as too much of a surprise. Emerging market currencies often have problems following the Fed’s tightening. Most famously, Latin America was plunged into a deep, decades-long economic depression following former Fed Chair Paul Volcker’s massive rate hikes between 1979 and 1981. Following the Fed’s 1994 rate hikes, the Mexican peso wasted no time in collapsing and was followed a few years later by the Thai baht, many other Asian currencies, and then the Russian ruble. Currency disruptions in emerging market countries are growth killers. Existing borrowings in U.S. dollars or other hard currencies become extremely hard to service. Domestic businesses and consumers pull back spending in a downward spiral. Political uncertainties, often already high, get even more convoluted as emergency policies are enacted and interest rates go sky high. As emerging market countries have taken an increasingly larger share of global economic activity over the last few decades, their impact on global growth and the knock-on effects to the major industrial countries has increased.


Between 2009 and 2016, investors grew accustomed to financing long positions in emerging market currencies with interest-free loans in the U.S., European, Japanese or other zero-rate currencies. Now that the Fed has hiked repeatedly and plans to increase rates even more, these currency-carry trades are unwinding in a hurry.


Moreover, high debt levels exacerbate emerging market stress. China has taken on extremely high levels of debt that resembles those of developed nations and is currently trying to deleverage. The problem for China is that its deleveraging plan is not a deleveraging plan at all. Basically, China’s so-called deleveraging plan moves debt from point A (the shadow banking system, non-financial corporations and local governments) to point B (the official banking system, the central government and, indirectly, household balance sheets). Moving debt from one place to another doesn’t achieve deleveraging but it can make debt more manageable. The government is trying to stave off an economic slowdown with an upcoming tax cut, scheduled for September, while the People’s Bank of China is reducing its reserve requirement ratio to spur lending. Given China’s debt burdens and the cost of the trade war with the United States, it seems unlikely that these measures can ward off slower growth. Finally, China’s debt levels may be understated by as much as 10-20% of GDP once local government debt is accounted for.


A clear consequence of economic disruption and slowing growth in emerging market countries is the plunging prices for industrial metals. Copper prices fell by almost 20% in June and July 2018. Oil demand has held up so far, but downward pressure on prices is typical in an emerging market currency disruption period.


Figure 2: Is the Next Emerging Market FX Crisis Underway?


100 105 110


45 50 55 60 65 70 75 80 85 90 95


Jan-18 Feb-18 Mar-18 Apr-18 May-18 Source: Bloomberg Professional Jun-18 Jul-18 Bloomberg Professional (ARS, BRL, CNH, RUB and TRY) Aug-18 Year to Date versus USD: January 1, 2018 = 100


China: Offshore RMB


Russian Ruble Brazilian Real


RISK #3: TRADE WAR


Our take on the current U.S.-initiated trade war is that it has two effects that raise recession risks. First, the trade war disrupts business planning and potentially raises costs related to supply chain management, and in so doing, decreases corporate profits overall (although a few specific companies will benefit). Second, the trade war hurts the Chinese economy and exacerbates the slowdown in growth. The U.S. economy may look quite healthy in the rear-view mirror, appearing more than able to withstand some trade challenges. However, with economic risks already rising from rate hikes and emerging market FX disruptions, the next bump on the road could prove critical. And, the trade war may simply be the straw that breaks the camel’s back.


Corporate profits are likely to come under downward pressure. Falling corporate profits do not necessarily doom the equity bull market, at least in the short run. The previous two bull markets went through two phases. In the first phase (1990- 97 and 2003-2005), earnings and equity prices rose together. In the second phase (1997-2000 and 2006-2007), earnings fell but equity prices rose anyway (Figure 4). Earnings essentially have plateaued since 2014, before being goosed up by the corporate tax cut. With the tax cut impact fully priced into the market, earnings may begin to decline in the second half of 2018. Even so, the actual peak in the equity market might not come until 2019, 2020 or later, depending on whether a recession materializes.


Erik Norland E: erik.norland@cmegroup.com Turkish Lira


Argentine Peso


Sep-18


All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.


29 | ADMISI - The Ghost In The Machine | September/October 2018


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