Financial Crisis Early Warning System

by: Eric Parnell, CFA

Social unrest is exploding across many parts of the world. In the past week alone we have witnessed scenes of violence erupt in several emerging market countries in different parts of the world. While the unfolding events are important to monitor closely from a geopolitical and humanitarian perspective, it is also important to consider the following - at what point might these events start to have an impact on investment markets including stocks (NYSEARCA:SPY)? For if the financial stability of any of these at-risk countries starts to crumble, the threat of a global financial contagion could soon follow as the fallout effects have the potential to be the catalyst for the next major market crisis. In monitoring the situation, two key market indicators are readily available to keep investors informed as to whether further action is needed.

The risks currently facing the emerging world are high and rising. Many nations have already been facing mounting financial pressures due to the spillover effects associated with the tapering of stimulus by the U.S. Federal Reserve. Leading among these are what some are referring to as the "fragile five" of Brazil (NYSEARCA:EWZ), Turkey (NYSEARCA:TUR), India (NYSEARCA:EPI), Indonesia (NYSEARCA:IDX) and South Africa (NYSEARCA:EZA). All of these countries have sizable current account deficits and are facing the risk of meaningful capital outflows as the liquidity that poured in from the extraordinarily aggressive monetary stimulus programs such as quantitative easing from the U.S. Federal Reserve starts to drain its way back out. The IMF was the latest to highlight the risk facing these countries with their calls for India to prepare an emergency rupee plan if volatility were to erupt with the Fed continuing to taper stimulus.

Adding to the uncertainty has been the increasing social unrest that has been escalating as we move through 2014. Countries at the heart of this issue include Ukraine, Venezuela, Thailand (NYSEARCA:THD) and Turkey.

Where financial concerns have become most immediate is in Ukraine, which is facing $13 billion in debt repayments this year and currently lacks the financial resources to meet these payments. The Ukrainian government had reached a deal with Russia for a $15 billion aid package back in December, which in many respects is likely at the core of the reason why the Ukrainian government spurned the trade deal with the European Union that sparked the protests in the first place. But if this aid package were to be canceled, which is possible for a variety of reasons, Ukraine may then be forced to seek out a rescue deal from the IMF or risk defaulting on its debt.

Venezuela is also facing its share of financial challenges, as the ability to effectively service its debt is coming under pressure from the increasing deteriorating economy in the country. The one advantage Venezuela has that is bolstering lender confidence at least for now is its vast oil reserves. But if political or economic conditions continue to worsen, the confidence that the country will actually repay its debt may increasingly come into question.

In addition to the countries already mentioned that are facing financial and/or social pressures, two others also merit attention.

The first is Argentina, which is once again on the brink of default as it works to delay pending debt repayments.

The second is arguably the most significant of them all in China (NYSEARCA:FXI), which has accumulated more than $18 trillion in total debt and is coping with the challenges of slowing growth while trying to safely withdraw stimulus from an economy that is showing signs of froth and highly speculative lending activity in many segments of its economy including real estate.

In all, we have ten emerging market economies that are garnering headlines and facing meaningful challenges on the financial, social and/or economic fronts for a variety of reasons. Investors should certainly not ignore such risks, as conditions like these are from which global financial contagions are born. But exactly how can we monitor the situation to be able to effectively differentiate what is news and what is something that requires us to take action in our investment portfolios?

Two key market indicators provide an effective early warning system against the threat of financial contagion being sparked from the emerging world. These are the two main emerging market sovereign debt exchange traded funds in the iShares JP Morgan USD Emerging Market Bond Fund (NYSEARCA:EMB) and the PowerShares Emerging Market Sovereign Debt Portfolio (NYSEARCA:PCY). The focus on the sovereign debt side is particularly important, for while equity market volatility is to be expected across these emerging economies, a sustained sharp decline in bond prices is most likely indicative of something far more severe.

The iShares JP Morgan USD Emerging Market Bond Fund has the following weighting to the emerging market economies considered either most at risk or at least worth monitoring for potential instability in the months ahead.

6.01% Brazil

5.92% Turkey

5.25% Indonesia

3.78% South Africa

3.55% Venezuela

3.11% China

2.80% Ukraine

1.87% Argentina

In short, roughly one-third of the EMB is directly exposed to the sovereign debt of these notable countries.

As for the PowerShares Emerging Market Sovereign Debt Portfolio, it is different from the EMB in that it is designed to be an equal weighted portfolio across roughly 20 to 25 sovereign countries. The following are the weighting to the notable emerging market economies.

4.32% South Africa

4.11% Turkey

4.09% Brazil

4.08% Indonesia

3.97% Ukraine

3.36% Venezuela

In the case of the PCY, it has a relatively smaller weighting directly to these economies at roughly one quarter of the portfolio. But what is particularly instructive about monitoring the PCY is that through its equal weighted strategy it provides insight into exactly what at-risk economies are coming under the most stress in terms of their debt. In this case, Venezuela stands out even more so than the Ukraine.

But despite all of the understandable concern over emerging markets since the start of the year, the early warning signal of sovereign debt prices in aggregate continues to remain relatively calm. In fact, a recent episode that was far more worrisome from a financial market stability standpoint was the events from May and June of 2013 when these sovereign debt markets were collectively down by as much as -20% in the matter of a few weeks. Contrasting that to today, both of these readings have recently risen back above their respective 200-day moving averages for the first time since late May, albeit at lower absolute levels.

Despite general signs of stability to this point, the EMB and PCY are worth monitoring closely going forward as part of an early warning system for the next crisis episode. For if we begin to see a material decline in the value of the bonds of these emerging markets most at risk, the negative effects have the potential to spread quickly through the rest of the financial system.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

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.

Additional disclosure: I am long stocks via the SPLV and XLU as well as selected individual names. I also hold a sizeable allocation to cash at the present time.