There once was a wide group of nations
Whose growth was built on weak foundations
Their policy actions
Are seen as subtractions
Increasing investor frustrations
Boy, I go away for a few days and world virtually collapses!!!
Needless to say, a lot has happened since I last wrote on Thursday, with a number of emerging market currencies and their respective equity markets really coming under pressure. It was the usual suspects; Turkey, Argentina, Indonesia, Brazil, Mexico, Russia and China, all of whom had felt significant pressure at various times during the year. But this new wave seems a bit more stressful in that prior to the past few days, each one had experienced a problem of its own, but since Friday, markets have pummeled them all together. This appears to be the contagion that had been feared by both investors and policymakers. The thing is, the unifying theme to pretty much all these markets is the stronger dollar. As the dollar resumes its strengthening trend, both companies and governments in those nations are finding it increasingly difficult to handle their debt loads. And given the near certainty that the Fed is going to continue its steady policy tightening alongside consistently stronger US economic data, the dollar strengthening trend seems likely to remain in tact for a while yet.
Could this be one of the ‘unexpected’ consequences of ten years of QE, ZIRP and NIRP? Apparently, despite assurances from esteemed central bankers like Ben Bernanke, Janet Yellen and Mario Draghi (as dovish a triumvirate as has ever been seen), there ARE negative consequences to dramatically changing the way monetary policy is handled, massively expanding balance sheets and driving real interest rates to significant negative levels. While there is no doubt that developed economy stock markets have benefitted generally, it seems like some of those risks are becoming more apparent.
These risks include things like the central bankers’ loss of control over markets. After all, markets around the world have basically danced to the tune of free money for the past decade. As that tune changes, investor behavior is sure to change as well. Another systemic risk has been the increasing inability of investors to adequately diversify their portfolios. If every market rises due to exogenous variables, like zero interest rates, then how can prudent investors manage their risk? Many took comfort in the fact that market volatility had declined so significantly, implying that systemic risk was reduced on net. However, what we have observed in 2018 is that volatility is not, in fact, dead, but had merely been anaesthetized by that free money.
The worrying thing is there is no reason to believe that this process is going to end soon. Rather, I fear that it may just be beginning. There are a significant number of excesses to wring out of the markets, and however much central bankers around the world try to prevent that from happening, they cannot hold back the tide forever. At some point, and it could be coming sooner than you think, markets are going adjust despite all the efforts of Powell, Draghi, Carney, Kuroda and their brethren. Never forget that the market is far bigger than any one nation.
We are already seeing how this can play out in some of the above-mentioned countries. Argentina, for example, has short-term interest rates of 60%, inflation of ‘only’ 31%, and therefore real interest rates are now +29%! But the economy is back in recession, having shrunk 6.7% last quarter, and the current account deficit remains a significant problem. So despite jacking rates to 60%, the currency has fallen 22% this week and 120% this year! And they are following orthodox monetary policy. Turkey, on the other hand, has been unwilling to bend to orthodoxy (when it comes to monetary policy) and has kept rates low such that real interest rates are near zero and heading negative as inflation continues its climb (17.9% in September) while rates remain on hold. So the fact that the lira is down 9% this week and 95% this year should be less surprising.
The point is that the market is losing its taste for discrimination and is beginning to treat all currencies under the rubric ‘emerging markets’ as the same. And they are selling them all. As long as the Fed continues its grind higher in rates, there is no reason to believe that this will end. And if these declines are steady, rather than sharp crashes, it will go on for a while. Chairman Powell will have no reason to stop if a few random EMG markets trend lower. If, however, the S&P 500 starts to suffer, that may be a different story, and one we will all watch with great interest!
In the meantime, turning to G10 currencies, the dollar is stronger here as well this morning, although it has fallen back from its best levels of the morning. In fact, while the pound has been consistently undermined (-0.3% today, -1.5% since Thursday) by what seems to be a worsening saga regarding Brexit, the euro has stabilized for now, although it is down about 1% since Thursday as well. Apparently, CAD is not taking the ongoing NAFTA negotiations that well, as it has fallen 2% since Thursday amid pressure on PM Trudeau to cave into US demands. The BOC meets today and while there had been previous expectations that they may raise rates, that has been pushed back to October now in view of the NAFTA process. This is despite the fact that inflation in Canada is running at 2.9%, well above target.
In the end, as long as the Fed continues along its recent path, expect market volatility to increase further, with more and more dominoes likely to fall.
As to today, the only noteworthy data is the Balance of Trade, where expectations are for a $50.3B outcome, not exactly what the president is hoping for, I’m sure. And as far as the dollar goes, there is no reason to believe that its recent strength is going to turn around anytime soon.