Why the Fed Doesn’t Want Emerging Markets to Run

Yesterday, the ASX 200 closed below 5,000 points for the first time since late September. It tried to bounce higher a few times, but couldn’t. The index actually closed less than a point away from its low. This is an indication of heavy selling and suggests further falls are ahead.

Thanks to a late bounce in stocks in US trading overnight, there’s a bit of respite in store for Aussie stocks today. But the ASX 200 is still well below support at 5,000 points.

I’ve written for months now that 5,000 is a crucial level for the Aussie market. A sustained break below here suggests this bear market is entering a new and nastier phase.

But there is nuance to this analysis. It’s not as simple as just saying a fall below 5,000 points means the bear market will get worse. You’ve got to look a little deeper.

Looking deeper is something I will be doing for subscribers of Crisis & Opportunity this week, so out of respect for them, I won’t go into too much detail here. But I will say that the break below 5,000 this week might not be as bad as it seems. A few other things have to go wrong before you get seriously worried about where this market is headed.

Mind you, there is plenty of scope for things to go wrong. Firstly, the mid year budget update, due out today, should provide a wake-up call to anyone who thinks things are travelling along nicely.

That is, it should make it clear just how busted the Federal budget is. With iron ore, coal, gas and other commodity prices tanking, and with wages growth at multi-year lows, the government just won’t get the growth in tax receipts it needs to fund its promises.

Without spending reform, the budget will just keep getting worse. But there won’t be any spending reform if the government doesn’t first outline the problem. Under the ‘leadership’ of Abbott and Hockey, there was no intention to raise awareness of the problem because there was no intention to enact structural reforms.

It appears as though Turnbull and Morrison are interested in doing something. But to do that, they need to tell us how bad things are. That’s not going to be good for confidence in the lead up to Christmas. Santa Claus is definitely not coming to town. He’s not even coming to the country.

What else could go wrong?

Keep your eye on the banks. It’s all about their ability to maintain dividends. If this dividend support goes, the trapdoor will open and the market will dive.

More immediately, there’s the looming US rate decision. The market is panicking, selling off just like it did mid year, when it assumed rates would rise in September.

As Bloomberg reports:

Once again, the Federal Reserve is about to make a historic interest-rate decision against a backdrop of rising equity volatility, tumbling commodity prices and jitters in credit markets. This time, investors expect policy makers to pull the trigger.

In the lead-up to the Dec. 16 decision, investors are contending with crude below $36 a barrel, stress in the U.S. junk-debt market and the longest streak of losses in global equities since August. While the financial turmoil spurred by China’s yuan devaluation that month stayed the Fed’s hand in September, policy makers have since signaled increasing determination to go ahead with the first rate increase since 2006.  

The Fed really has no other choice. They will have to raise rates this week. Otherwise the ‘market’ will have them in a corner and it will be obvious who the boss really is.

This time the problems are in the high yield, or ‘junk bond’ markets. The collapse in commodity prices (particularly oil) is finally working its way through to the balance sheets of the companies that produce these goods.

This is how it’s meant to work. Low prices eventually bring about a supply response. To cut supply, you need to cut financing. With a huge amount of financing occurring through the junk bond market in recent years, the current turmoil should not be surprising.

This is just how the commodity cycle works. Although easy credit made this cycle much worse by giving marginal producers access to funds they normally would not have received.

So problems in the junk bond market should not be an excuse for the Fed to hold off raising rates. But the issue is one of contagion. That is, will losses in the junk bond market spark selling elsewhere…which will lead to a general credit crunch?

A similar threat is playing out in emerging markets. This is really just a continuation of what’s been happening for the past six months. That is, many emerging market economies borrowed heavily in US dollars. And many rely on commodities to generate revenues in their local currency.

The combination of falling local currency revenues and rising debt in US dollars is a toxic one. The market’s response is to sell assets in these countries, which sends their currency lower and interest rates higher. And that only makes things worse.

According to the Wall Street Journal:

Corporate debt in emerging markets had more than quadrupled in the decade to 2014, according to International Monetary Fund figures. But investors have been pulling money out of the market this year, spooked by signs that borrowing was ballooning unsustainably ahead of an imminent rate increase by the Federal Reserve.’

So far it’s only a quick walk to the exits. The Fed will be hoping that their first interest rate rise in a decade doesn’t turn it into a run.

If it does, you can expect to see the return of QE early in 2016. And plenty of market turmoil.


Greg Canavan,

For Markets and Money

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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