The Emerging Market Crisis

istanbul 06052013

The fourth quarter real estate in Singapore turned down showing that the whole Emerging Markets did tend to peak out with the ECM last August. This has led to a flight of investors from the once-booming emerging markets sector that is similar to the shift in what we began to see in 1994 that manifested into the 1997 Asian Currency Crisis. Previously, international investors poured in some $7 trillion-worth of capital inflows into these emerging markets. This shift in capital outflows for emerging markets has only just begun. The details of the capital flows for 2013 have shown that so far it is retail rather than institutional. The outflows amounted to just over $50 billion. This is also how things started in 1994. Eventually, institutional capital left violently in 1997 to get ready for the birth of the Euro in 1998.

In this case, the leader of the trend has not been institutions, but the retail market investors. It has mainly been this group that has packed their bags and moved back to the USA and European share markets. When the big institutional firms join in, reducing their asset allocation models, then we run the risk of a serious wholesale capital flight as we saw in 1997.

China is starting to slow down and the share markets have established their major high back in 2007 and penetrating the 2013 low in 2014, will warn that China could decline all the way into 2020. The global impact of a wind-down in U.S. monetary stimulus has been greatly exaggerated. Nevertheless, this has fueled the image of a bearish trend for China and the emerging markets in general. We are seeing this manifest also in the currency markets with record lows unfolding in Argentina, Turkey, and Russia. The alternative shift has been into the Swiss, Japanese yen, and US Treasuries. This is a shift in capital flows that is what many see as a sign of global contagion. The bottom-line, they are selling even high-yielding emerging market debt.

Because looking ahead, we see the dollar rally on the horizon and this will accelerate losses in emerging markets for foreign investors. That will cause fears to surface and force the big institutional investors to cut their losses and run as the impact of a rising dollar is mirrored into a collapse in these currency values. International investment is always first-and-foremost a currency crisis. This is true if it is the foreign capital investing in the USA, as in 1987, or Japan back in 1989, Southeast Asia in 1997 and Russia in 1998 just for examples.

The capital flows have clearly shifted out of the emerging market economies and this will force institutions to lower their asset allocation models for this type of investment. This is both a cyclical but also a structural problem for we have serious economic issues in Europe and rising taxation that is simultaneously impacting international investment. Many of the emerging markets in domestic terms appear flat, but in currency terms they appear to be a disaster. The US dollar has risen almost 2% in the last quarter against a basket of these currencies and this sparks the decline in assets and the shift in capital flows. These have been 13 consecutive weeks of capital outflows so far similar to the 1990s.

The key is always currency and what we haven’t seen in emerging markets is major currency devaluation just yet. The serious outflows hitting Argentina can spread as investors often sell everything as groups. We are likely to see continued capital outflows going into September 2014. With the rising civil unrest, this trend is likely to extend into the bottom of the ECM in January 2020.

World Bank has even warned of the risk of a sudden stop in capital flows for emerging markets, a point which was discussed by the International Monetary Fund as well. Clearly, long-term interest rates are subject to a sudden rise of as much as 200 basis points as civil unrest rises. We are likely to see a collapse in capital inflows for this sector by at least 70%. The rise in civil unrest is likely to inspire a contagion to sell everything in the years ahead. When US long-term rates 4%, up from the 2.7% current levels, emerging markets will move into a serious decline.