Warning In The Emerging Markets
Summary
- As the US dollar rises, emerging market debt is plunging.
- Emerging market debt is heading back towards the 2016 lows.
- The US dollar is up, but only slightly, begging the question as to what happens if the dollar rises back to 2014 highs?
The US dollar declined sharply for nearly the entire year of 2017 when 'global synchronized growth' was all but a unanimous call on Wall Street. Historically, when global growth is robust, the dollar declines and foreign currencies benefit and when global growth slows or there is a global recession, the US dollar rises.
Back in 2017, I wrote many notes to members of EPB Macro Research warning about not only a US economic slowdown but a global growth slowdown as well.
It took a fair amount of time for that thesis to play out but now, five months into 2018, much of the data out of Europe and other major foreign countries is deteriorating rapidly, causing the US dollar to rise and other currencies to depreciate relative to the dollar.
Back in early April, I wrote a note to subscribers informing them to watch the US dollar and its rise as a confirming signal of our current thesis of a global growth slowdown in 2018 and 2019.
Interestingly, the dollar has seemingly bottomed after a multi-month decline. The dollar (UUP) is one of few currencies up over the past one month and the past one week.
A strong outperformance in the US dollar is a leading indicator of global weakness. A bottom and subsequent sharp rise in the US dollar (UUP) is something to watch out for as a confirmation of a global economic slowdown.
- April 8, 2018, EPB Macro Research
Before moving on to the actual move in the US dollar and the major impact it is having on emerging market debt most specifically, I think it is important to point out a few 'canary in the coal mine' data points that emphasize the pending global slowdown and subsequent rise in the dollar.
Euro Area PMI:
Source: Trading Economics
The PMI readings out of Europe were a major bullish data point for most analysts claiming 'global growth'. The PMI readings in the Euro Area as a whole are near a 12-month low and have declined sharply from the January 2018 peak.
Secondly and perhaps more interest is what is happening in South Korea. South Korea is a major exporting country and a key player in the global economy. South Korea exports have turned negative on a year over year basis. Declining export growth was a precursor to the 'mini global recession' in late 2015, early 2016.
South Korea Exports Year over Year:
Source: Investing.com
As members of EPB Macro Research know, I am bullish on the US dollar (UUP) due to a pending global slowdown that can clearly be seen in the global economic data and the domestic economic data. The rising US dollar has been the result and it is causing damage around the world as it usually does. I am not in favor of a weak US dollar, I am simply pointing out the ramifications of a strong dollar in the global economy.
The US Dollar Index, on a broad basis, which includes currencies such as: Euro Area, Canada, Japan, Mexico, China, United Kingdom, Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Switzerland, Thailand, Philippines, Australia, Indonesia, India, Israel, Saudi Arabia, Russia, Sweden, Argentina, Venezuela, Chile, and Colombia, has been steadily rising since the start of 2018 (when Euro PMIs peaked).
US Dollar Index: Broad
Source: Federal Reserve, EPB Macro Research
Looking at the US dollar against only major currencies, which includes: Euro Area, Canada, Japan, United Kingdom, Switzerland, Australia, and Sweden, shows a similar picture over the past two years.
US Dollar Index: Major Currencies
Source: Federal Reserve, EPB Macro Research
The reason I look at the US dollar vs. both a broad basket of currencies and a major basket of currencies is because of the vast difference in performance since 1995.
Over the past 22 years, the dollar is up 27% compared to a broad basket of currencies but is nearly exactly flat, up only 0.28% over the same time period against major currencies.
US Dollar Index: Broad Vs. Major Currencies
Source: Federal Reserve, EPB Macro Research
Regardless of the basket you use for the rise that is occurring in 2018, the damage to emerging markets is clear.
Emerging market debt (EMB) has been in a free fall since January 2018 (peak in Euro PMI and Global Growth Data).
Emerging Market Debt
Source: YCharts, EPB Macro Research
As the US dollar rises, those who issued debt in dollars, but earned money in a local currency, are seeing the value of their debt service payments rise dramatically in real dollars.
The decline in emerging market debt has been severe and is almost back to the lows of 2015-2016 when the world experienced a major, yet acute, credit crisis.
Interestingly, emerging market equities have not shown the same decline as the debt indicating that the rise in the dollar and the increase in debt service payments is likely the main culprit of the pain in the emerging markets.
Emerging Market Equities (EEM)
Source: YCharts, EPB Macro Research
As global growth and US growth continue to slow throughout the rest of 2018 and into 2019, the dollar will likely continue to rise. As the dollar rises, the debt in emerging markets (issued in dollars) becomes dramatically more expensive and burdensome to repay.
Yes, some of the declines can be attributed to rising global rates but US debt has not experienced nearly the same decline.
Emerging market debt is down nearly twice as much as a similar duration treasury ETF (IEF) for 2018 thus far.
The declines in bonds around the world show a similar path, but as of the past several weeks, when the rise in the dollar has accelerated, the decline in emerging market debt relative to US debt has also accelerated.
Emerging market debt is sending a loud signal surrounding global growth and credit health outside the United States.
The US dollar will continue to rise as the Federal Reserve is aggressive with monetary policy despite slowing growth conditions in the United States and abroad.
Any marginal rise in the US dollar will bring more pain to emerging markets and emerging market debt more specifically.
What happens if the dollar strengthens back to the 2014 highs?
Emerging market debt (EMB) is a ticker that should be on everyone's radar screen as it pertains to global economic health and credit market conditions.
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Eric Basmajian
EPB Macro Research
"We see things differently. We do things differently"
This article was written by
Eric Basmajian is an economic cycle analyst and the Founder of EPB Macro Research, an economics-based research firm focusing on inflection points in economic growth and the impact on asset prices.
Prior to EPB Macro Research, Eric worked on the buy-side of the financial sector as an analyst at Panorama Partners, a quantitative hedge fund specializing in equity derivatives.
Eric holds a Bachelor’s degree in economics from New York University.
EPB Macro Research offers premium economic cycle research on Seeking Alpha.
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