The Reversing Markets: What Emerging Nations Are Forecasting

The 2000’s will be known in history as the decade of the emerging markets, as previously ignored names such as Brazil, India and China have made their presence known through unparalleled production numbers and a growing base of tech-savvy and versatile laborers. The shift in demographics, the loss of manufacturing jobs, and the flood of cheap (both in terms of price and quality) consumer goods is a reflection of this global transition. Yet, as in the laws of physics, what goes up must come down and emerging markets are no exception. In fact, the fundamental patterns we are witnessing today further confirms the likelihood that the best days of the developing nations are behind them.

First, it’s important to remove some of the mysticism that has permeated regarding the emerging market story, especially given the high double-digit growth numbers many such nations have posted in years past. These enormous gains have come as a result of exceeding generous threshold margins, where basic ingenuity and low expectations collide to form parabolic expansion. This is where the ROI curve is at its most productive; however, each threshold higher leads to stricter margins and higher expectations. It is at this point where deficits within the infrastructure of the emerging market are cruelly exposed. As individuals who strive to lose weight can relate to, the first several pounds are the easiest to lose: deeper into the exercise regiment, the last few are the toughest to shed.

Emerging markets cannot stay emerging forever: at some point, they must emerge or submerge. And they are certainly finding out just how tough it is to play in the majors: according to a recent Bloomberg article, $3.9 trillion flowed into emerging markets over the last four years alone. However, more than $19 billion have left these funds in the three weeks to June 12, 2013, leveling volatility not only within the funds but also in the currency exchange:

Malaysia’s ringgit depreciated 1.7 percent, the biggest drop since November 2011. The Russian ruble     declined 1.9 percent to an

11-month low and South Africa’s rand fell 2.9 percent, approaching the weakest     level in four years. Poland’s zloty sank as much as

2 percent versus the euro to the lowest in a year.

MSCI Inc.’s Emerging Markets stock index is down 13 percent this year, compared with a 14 percent     advance in the Standard & Poor’s 500 Index. The developing-nation measure is trailing the U.S. benchmark     by the most since 1998.  (http://www.bloomberg.com/news/2013-06-20/emerging-markets-crack-as-3-9-trillion-funds-unwind-currencies.html)

The main culprit is the Federal Reserve and their warning (some say threat) that they will taper-off their eponymous QE program. Such speculation first devastated the commodities market, then the global markets (particularly in Japan), and then finally, the U.S. stock market. 10-year yields ran ahead of the crowd, galloping through large swathes of basis points to reach levels not seen in two years. Of course, the big concern amongst global investors is the unmitigated rise of the dollar, which represents a deflationary headwind that is far more pernicious than an inflationary one.

Although short-term swings are always difficult to forecast, the dollar clearly wants to move to 84 and beyond: it already has gapped up to its 50 day moving average and with enticing yields causing a frothing of the mouth amongst FOREX traders, it’s no stretch of anyone’s imagination to see further gains. Also note that the Relative Strength Indicator and the MAC-D are both coming off of over-sold levels, which may mean that we are at the beginning stages of a major paper rally.

Of course, a stronger dollar should give American investors more leverage, thus making the emerging market play appealing. However, the outflow of money has been aggressive, as participants are spooked by growth-plateau and fundamental instability. Brazil, for example, is in the spot-light as they currently host the Confederations Cup, a warm-up tournament to FIFA’s World Cup. Yet the international media has been treated with another compelling story, as rising costs and a widening wealth disparity have brought increasingly violent protests to the streets of Sao Paulo. One can make a reasonable assumption that those in the know took their money out just in time:

The above chart shows the price action for the Brazil iShares ETF, where a devastating distribution of over 40 million shares blew out the last remaining candles of the emerging market cake. Happy birthday and welcome to your first year of high hopes and higher margins…now what are you going to do?
For many of the emerging names, this will be the first real test of their respective economies: those that are leveraged purely to cost margins will soon find that a stronger dollar brings better options.

Others that have been relying on cheap labor to boost growth metrics will discover that there will always be another person willing to work a little harder for a little less. Ultimately, names that can find success will have to rely on a healthy balance of innovation base, manufacturing productivity, and transparent facilitation of free market dynamics. It may be an overwhelming task for the emerging markets and that is one reason why money has left and will be in no hurry to return back.

Given this sentiment and conclusion, no matter how erroneous it may or may not be, investors closer to home should be wary of “buy the dips” marketing advice. While the valuations are certainly enticing, especially for the EWZ (which is at three-year lows), one needs to be aware that the institutional money has left. These are the players that move markets and they rarely swing back to an investment branch they previously abandoned seconds ago. Therefore, while shares can be picked up “on the cheap,” they might stay cheap for a longer than expected duration. While it is difficult to do, given the excitement that the global markets have launched, it may be far more safer to sit on the sidelines and build a cash position while the undercurrents work themselves out.