Let's say you are friends with Dr. Emmett "Doc" Brown, the scientist from "Back to the Future" and you both decide to take a trip back to the beginning of 1994. What you would see is after three years of low level interest rates, the Federal Reserve, in an effort to allow the financial sector industry to heal from unprofitable expansion and lending unexpectedly started to tighten. During the previous three years, as many investors sought yield, they purchased lower quality fixed income assets. However, after over a year of solid employment gains, the Fed decided to tighten. As a result, investors were caught off guard.
The economic conditions back then did not warrant tightening. The 1991-1993 recessions was comparatively a long one. Unemployment was still high and inflation was at its lowest level in years. Nevertheless, the Fed started with a modest increase in rates. The Treasury yields reversed course and rose rapidly causing havoc among leveraged financial institutions.
Buffet once wrote "Only when the tide goes out do you discover who's been swimming naked." Conversely, only when the tide comes back do you discover who's unable to swim. Luckily, the Fed this time is giving us a life buoy, communicating its decision with increasing clarity. In its latest press release the Fed stated:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
As the unemployment and inflation normalizes, the Fed will see fit to tighten monetary supply by first reducing the purchases. However, if inflation breaches the Fed's upper bound, it could create a scenario of sharp rate increases as it plays catch up with rising inflation expectations. Even though most of our attention is on the U.S. rates, the real elephant in the room is the effect on emerging markets.
Our scenario is based on the premise that the Fed will respond to inflation pressures by tightening money supply (either selling its holdings or increasing rates). As the U.S. increases the rates, capital will return to the U.S., strengthening its currency against emerging markets currency. As the emerging market currency weakens, imports will become more expensive and inflation will start to rise. The rising cost of capital will lead to lower capital investment, which will cause lower growth in the long run, causing a revaluation in multiples across all markets. Additionally, there is potential for political disruptions, further increasing the risk of owning emerging securities. As the world's central bankers respond by raising interest rates, economic growth will stall; some countries will eventually restructure their balance sheet. Export economies will recover quickly.
This scenario is reminiscent of the 1998 Asian crisis but with significant differences, including the strength of many Asian economies. The economies are not as levered as they were in 1998 and there are mechanisms of adjustment (floating currencies), leading to the likelihood of lesser extreme outcomes. We see evidence of this scenario already unfolding in India. Weak currency leading to inflation and as consequence, the central bank has raised rates and cut its outlook on growth.
Our long-tail scenario is the slowdown of China. The catalyst is a sharp increase in worldwide interest rates that will put a strain in the Chinese financial system. Internal liquidity could dry up and slow down the entire economy. Recently, the Economist reported that the Shanghai Interbank Offer Rate (SHIBOR) shot up to 12%. To counterbalance these forces, China would be forced to sell their assets (including U.S. Treasuries) aggravating the situation and creating dislocation in the markets, an opportunity for those who can swim in strong currents.
Our bet is on the U.S. and European economies. Corporations and consumers have had almost five years of balance sheet healing, allowing them to tolerate a weak emerging market. We prefer to invest in companies that mostly sell to U.S. and European markets but source their products or services from emerging markets. A stronger dollar and euro will lead to cheaper imports and thus industries such as apparel (NYSEARCA:XRT) will benefit.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.