We have been discussing some global macro themes in recent months and what we are likely to see as a result of the Fed tightening rates. Obviously one major thematic which has been a firm trend over the past 18 months is the strength of the US dollar. The repercussions of this strength falls heavily on emerging market economies – Latin America, Asia and the Middle East.
These economies benefited over the past decade from rising commodity prices and capital inflows from the falling US dollar and the quantitative easing programs of the Federal Reserve. Cheap money from the US flowed into these economies chasing high returns not only from equities but from Government and corporate bonds. Now the taps to these flows have not only stopped but are reversing (rate hikes) these investment flows are reversing.
These investment outflows combined with falling commodity prices is a Molotov cocktail for asset prices in their regions. Due to the high spending periods of Governments over the past decade on the belief record commodity prices were here to stay, these regions are now running serious budget deficits and risks are rising of widespread defaults with an ability to payback all that borrowed money.
As a result of these risks bond prices are plummeting (yields rising) and equity prices are also at dangerous levels. Below we show the JP Morgan Emerging markets bond ETF (EMB) and the MSCI Emerging Markets Index ETF (EEM). Recalling we highlighted several months ago the importance of the High Yield Corporate Bond ETF (HYG) – the EMB and EEM are the equivalent for the emerging market regions. These are in well set trends and while we might see a relief rally after the first Fed rate hike – this is the place where the next GFC-style collapse will occur.
Emerging Markets Bond ETF – verge of breaking down
MSCI Emerging Markets ETF – about to hit 5 year lows
The timing of the GFC-style unraveling in emerging markets may not occur for another 6 months after the Fed hikes 2 or 3 times but it is clearly an unsustainable situation and in our view a ticking time bomb.
The flip side to these flows is those economies and regions that will be beneficiaries. After all money chasing high returns doesn’t just cease. Again we revert to our recent discussions on Europe and the likely rally to emerge once the Greek debacle was resolved. This has now occurred, European equity markets have revived and the European Central Bank still has their quantitative easing program in place until September 2016. More importantly economic data from the region continues to be robust and above expectations.
Germany and France remain the core “safe” markets of the region and we nominated Henderson Group (HGG) in June to Share Café readers as the best way for local investors to gain European exposure. After its recent solid profit result the stock trades at a record high. But just as the core markets of Germany and France have been the leading equity market performers of the Euro zone, we see significant potential for a catch-up from peripheral Euro zone markets. These economies are improving, valuations are still attractive and offer huge leverage to ECB stimulus and any acceleration in economic growth. Much like what emerging markets offered a decade ago.
Germany is trading just off record highs and France is within a whisker of fresh new multi-year highs which themselves are not far off record highs as well. However of most interest now is Italy. This is the peripheral country that stands to benefit most from an uptick in economic activity as it ranks next behind France in GDP size, yet as the charts below show has staged very little gains to date.
A breakout here which technically looks highly probable completes a long multi-year base formation which from the second weekly chart could lead to a substantial recovery given still how close Italy is to its GFC lows. We could easily find that flows out emerging markets end up in peripheral countries like Italy that offer extreme leverage to a European recovery without the risks of bond default and falling commodity prices.
Many trading platforms now give access to these markets and ETFs so local investors are able to profit from these diverging trends. So if you are a bear – short emerging markets and if a bull – buy Europe and specifically the Italian MIB index. Like always there is something for everyone no matter what outlook you have as the Federal Reserve looks to trigger more than just a simple 25 basis point increase in rates. The ripple effects will be huge.
Italian MIB – daily chart building for a solid break higher
Italian MIB – weekly chart shows the length of this base and how little recovery has occurred here despite the records highs on the German DAX and rally in France CAC 40.
