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September 12, 2018

Investors Are Facing Tripple Treats

To millennials like my daughter, Bob Dylan is a museum piece. But to my generation, his music still resonates. Sure enough, as I surveyed this morning’s headlines, the Dylan tune Shelter from the Storm popped into my head.
Just as Hurricane Florence is gathering strength off the East Coast, a financial storm from overseas is about to hit our shores. Emerging markets face darkening clouds; you need to shelter your portfolio.
Stocks nonetheless rose today, as trade conflict and emerging market turmoil were put aside in favor of robust corporate earnings. Rebounding technology shares led the way.
The mindless cheerleaders on CNBC shout rah! rah! rah! at milestones, such as when Apple (NSDQ: AAPL) last month hit a market cap of $1 trillion. However, the escalating crisis in emerging markets gets short shrift. The topic is deemed too “wonkish” and bad for ratings.
Below, I’ll explain why you should pay close attention to emerging market chaos and what it means for your portfolio.
Triple threats…
Below are three charts that when put together, tell a troubling story.
Ten years ago this week, investment bank Lehman Brothers collapsed because of toxic loans and securities tied to real estate. It was the biggest bankruptcy in history, triggering global contagion.
The lessons of 2008 remain unheeded.
The extravagant corporate tax cuts signed into law in December 2017 are generating a massive federal deficit. The non-partisan Congressional Budget Office reported today that the deficit hit $895 billion in the first 11 months of fiscal 2018, an increase of $222 billion, or 32% over the same period the previous year.
At the deficit mushrooms, Congress is eagerly dismantling the regulatory reforms that were imposed in the wake of the 2008-2009 financial crisis.
Lack of budgetary wherewithal combined with decimated safeguards will make the next crisis far more severe and all the harder to contain.
Over the past decade, rock bottom interest rates have induced emerging market governments to borrow heavily. Since 2007, total issuance of U.S. dollar-denominated bonds by emerging countries has doubled to more than $11 trillion.
Companies in these markets have splurged on debt as well. In fact, corporate debt in emerging economies is now substantially greater than it was before the 2008 crisis.
The pressure on emerging markets will intensify, as the U.S. dollar further strengthens. Last Friday’s non-farm payroll report from the Labor Department showed that average hourly earnings growth had reached a nine-year high, indicating that inflation will heat up.
Wage growth has helped drive two-year Treasury yields to levels not witnessed since 2007 (see chart, compiled with data from Bloomberg):

To dampen inflationary pressures, the Federal Reserve is expected to announce another interest rate hike, at its next meeting Sept. 25-26. Rising rates are fueling the inexorable rise of the greenback, which is worsening the emerging market currency crisis.
Many emerging markets are struggling with onerous dollar-denominated debt, economic mismanagement, domestic political unrest, and export headwinds generated by trade war.
Rising oil prices add to the burden for emerging markets, because they pay for crude in U.S. dollars. A high dollar against the respective local currency makes oil costlier.
The dollar recently hit a 13-month high against a basket of foreign currencies. And as the chart shows, oil prices are embarked on a sustained upward trajectory (data from the U.S. Energy Information Administration):

West Texas Intermediate today jumped 2.81% to close at $69.44 per barrel. Brent North Sea crude rose 2.34% to close at $79.18/bbl.
As oil prices soar, currencies in several emerging markets are plummeting. Among the hardest hit are Argentina and Turkey.
Argentina’s collapsing currency recently prompted the government to approach the International Monetary Fund to secure a $50 billion loan. Negotiations over the conditions of that loan are continuing this week.
Meanwhile, investor confidence in Turkey has waned, as that country engages in a tariff battle with the Trump administration. Turkey is a key NATO ally and a major outsourcing destination for many Western blue-chip manufacturers.
The chart, compiled with data from Haver Analytics, shows the dizzying declines of the Argentine peso and the Turkish lira:

The upshot: with the greenback in a bull market, it’s more difficult for internationally denominated assets outside of the U.S. to perform as well as local assets for U.S. investors. It’s prudent to pare back your stakes in assets with significant exposure to emerging markets.
An emerging market meltdown would quickly infect developed economies. Stay invested but elevate your cash levels and transition away from momentum stocks. Portfolio allocations that generally make sense now are 35% stocks, 35% hedges, 20% cash, and 10% bonds.
As the markets enter a highly uncertain period, take proactive steps now. As Bob Dylan sang: “You don’t need a weatherman, to know which way the wind blows.”
Courtesy of John Persino, Investing Daily (More from Investing Daily Here
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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