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“The simplification of anything is always sensational.”

Gilbert K. Chesterton


Commentary & Analysis

Emerging or Sub-merging Markets? A trade idea

To be altogether comfortable with shorting the emerging markets I think you have to also be comfortable with our (and others) US dollar bull market call.  If you are a newsletter guru devotee, you probably know the story by now—the dollar is going to crash.  These siren calls of dollar doom have been with us for many years.  At times the calls grow loud.  But at all times they have been wrong.  The dollar game isn’t about finding all the things wrong with the United States—there is a laundry list there I know.  It isn’t about trumping up scenarios about “currency wars” that never happened and going on TV or holding seminars to promote said illusions.  But, it is about understanding what is happening on a global macro basis across the global economy.  Many of the rationales that may power the dollar higher are the same that seem dangerous for emerging markets.

Here are the down and dirty rationales for shorting emerging markets:

US dollar credit is draining off the global economy—dollar bullish long term:

The improving US current account deficit means fewer dollars are sent out to lubricate other markets. This is especially dangerous for countries which lack capital market depth and are more highly dependent on bank and trade flow financing—that defines emerging markets for the most part. An interesting coincidence with the US Current Account and path of the US dollar in the chart below:

The United States’ growing energy dominance represents a powerful magnet for long-term investment flows into the United States.  Energy costs for companies operating inside the US (and Canada) is significantly lower than for those in Europe, Japan, or China (and emerging markets); that represents a significant competitive advantage.

The Fed’s zero interest rate policy continues to lay waste to the real economy here and abroad, further exacerbating US consumer demand for foreign goods.  The saving grace for the US is depth of consumer market locally relative to emerging markets.  Thus, relative growth in the US should continue to improve against most EM countries.

US companies are bringing manufacturing jobs back to US shores as technology integration in manufacturing neuters the emerging market labor cost advantage (it isn’t a great boon for US employment but beneficial at the margin as catalyst for supply clusters) but it does spur capital flow back into the US.

Expectation of Fed taper improves relative US yields and pressures leveraged players who have stretched for yield in emerging markets to liquidate.

Although the emerging markets have made strides in improving local finances, they are still highly dependent on the center for demand and capital flow, i.e. deep old world consumer and capital markets.  Despite all the hoopla about BRICS taking over the world, the tried and true dynamic about center versus the periphery still applies.  Our emerging markets flow diagram describing this dynamic, created about five years ago, needs little in the way of updating. I expect the wheel is now rotating counter-clockwise for emerging markets, i.e. the self-reinforcing negative spiral should accelerate:

Trade Idea: Buy the Short MSCI Emerging Markets exchange traded fund; symbol is EUM—we shared this trade idea with subscribers to our Global Investor service on January 7th 2014.  If there is an EM crisis, this ETF should rocket higher.

If you want to consider subscribing to our Global Investor service, you can do so and find more information here.