Emerging Markets Are The Key

Most investors and financial analysts keep their eyes locked on the U.S. and European markets in order to take the pulse of the global economy. Shares on the New York Stock Exchange and the London Stock Exchange are among the most traded in the world, drawing money from every continent in just about every currency. The DJIA, S&P 500, and the FTSE 100 are the most popular indices in the world, representing constituents that make up trillions of the globe's wealth. But what if I told you that something's driving them? That developed economies are being driven instead of driving?

By 2030, ExcelFunds reports that emerging markets equities are expected to represent 55% of the global market capitalization by 2030. China's will, by itself, account for 28%. There is no questioning the power of developing economies. Their businesses and governments become power hungry vacuums demanding infrastructure, cheap services, construction, and just about every kind of raw material out there. If the particular country is not consuming, its revenues often become linked to the mass amounts of raw materials it produces, creating resource economies that grow robustly. In the same report, emerging economies' stock market performance beat the developed world by a whopping 5.5% over the past 15 years. The ravenous appetite of these countries allows investment opportunities to flourish, but when things turn sour, the world grimaces. 

Emerging Markets lead Dow Jones Industrial Average

During this particular economic period defined by low oil prices and low-interest rates, emerging markets have shown why they matter. There are many points in the beginning of 2015 where one can observe the emerging markets index leading indices from developed countries. We will use a comparison with the Dow Jones Industrial Average. Due to inclement economic data from developing countries, especially China, risk grew in their capital markets which caused investors to reevaluate their assets in U.S. and European equities. The green circle identifies a position where emerging market weakness (mostly caused by Chinese stock bubble) lead the losses in the Dow. Major equities in emerging countries also saw much larger losses over the same period of time. In fact, in just 3-months the deficit between the Dow Industrials and the GSCI Emerging Markets Index was more than 10%. The difference between the two held when they rebounded in early 2016 as well. Emerging markets recovered about 3.5% of their price back during the recovery. 

The chart above clearly shows that investors have been betting heavily on these markets to lead the way. With low-interest rates set by the Federal Reserve, U.S. investors have been more than happy to flood the developing capital markets with money, expecting a higher yield with minimized risk. Through the selling of corporate  bonds and sovereign debt, governments and corporations in the developing world have amassed an astounding $1.6 trillion worth of liabilities to be settled in between 2016 and 2020 as reported by The Globe and Mail. The report also cited a projection where that debt amount grows about $100 billion a year in that same time period. Most individuals would shake their head at this gargantuan bill that was created out of thin, but why wouldn't growth-hungry businesses take on such cheap debt. The bonds and debt didn't become a problem until expectations for interest rates changed. As money was supposed to get more expensive, the risk premiums on bonds in emerging markets scared off investors who promptly took as much money as they could and looked for something safer (and ironically, the T-bill provided safety and a higher expected yield).

Notable Developing Countries' GDP Growth Rate
from Trading Economics

But why should that trigger losses in the developed markets? The debt overload, higher risk premiums, and capital outflows created two things that directly affected developed markets. The first is lower demand from developing countries as a result of slower growth rates. The chart above shows the slowing of some of the largest emerging markets in the world. The second largest economy in the world in China slowed to growth rates below its targeted 7% (though some doubt the government's data). Both Brazil and Russia's growth rates dropped into below zero as it shed some of the girth of their economies in a global diet. Because the world's total economic growth relies so heavily on emerging markets, even these slight drops affected developed trade, investments, and currency dynamics. Financial Times said that the spread between emerging markets growth and developed markets growth was at a low 2.1% which hadn't been seen since 2000. It was almost as if a family of four sat down to eat dinner, but the father never showed up. That brings in the second reason, the leftovers. With demand from developing countries shrinking, commodities took a huge hit as businesses, which usually devoured them, went on a diet. The year 2015 will always be known for its huge losses in commodities which were most evident in the crude oil market. Developed inventories remained high with trade deficits growing because of less foreign demand. With prices dropping and the most loyal customers falling away, revenues started to be affected which cause equities to drop as well. 

For any investor still wondering why emerging markets are still the key to a sustained rebound, the answer's hidden in a change of psychology. The Federal Reserve has openly forecasted their wariness going into the upcoming meetings, meaning interest rates will most likely stay lower for longer. That translates to a debt environment that continues to be friendly to emerging markets who'll have to pay less interest. Many of the readers are now probably asking, "Rates have to go up eventually, right?" Probabilities calculated using the Fed Fund futures have assigned a mere 43% probability to rates increasing from 0.50% to 0.75%  in September of 2016. These projections don't really matter, though, because the Fed has already told us emerging markets are safe. Traders and economists shouldn't expect another hike until inflation has risen to a comfortable level and the threat from low oil prices has subsided. This will only occur when a broad-based commodity recovery has occurred, a signal that businesses in emerging markets are back at it again. The low-interest rate environment and stronger energy sector will then allow developed equities to return to safety as well. 

That's why emerging markets are the key because every economist at every central bank and investment firm is waiting for them to come back. Their rebound not only signals lower risk but the ability of traders to earn a higher yield in a low-interest rate environment.

Sources: The Globe and Mail, Financial Times, Excel Fund


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