Significant Emerging Markets Contagion Is Very Much Possible

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Includes: AGT, ARGT, AYT, CEW, JEM, PGD, UDN, USDU, UUP
by: Ivan Martchev

Another week and another all-time low for the Argentine peso, which registered its first weekly close above 40 per dollar, or 41.28 to be exact. At the end of 2017, the Argentine peso was changing hands at 18.59 against the dollar. Argentina has the weakest G20 currency, down 55% so far this year, followed closely by Turkey and its lira. The South African rand, the Indonesian rupiah and the Brazilian real also have issues, but not nearly as challenging as what is going on in Turkey and Argentina.

Argentinean Peso Index Graph

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The sad part is that the Argentines have been there before, and it does not take them long to bastardize a currency. The issue is the tendency of the central bank to run a very lax monetary policy with negative real interest rates. I remember many stories over the years about how most Argentines do not believe their government’s official inflation statistics. This causes them to hoard dollars, and for very good reasons, given the serial currency crises the peso is prone to. In the past 30 years the Argentines have managed to turn the peso into confetti three times, with the caveat that the third such cycle has not been completed.

Argentina Inflation Rate versus Argentina Lebac Rate Graph

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In a negative real interest rate environment, the economy gets a boost and grows faster than would be possible otherwise. But ultimately, the type of economic disaster that comes from the high inflation that typically accompanies a currency crisis ends up not being worth the sugar rush of negative real rates.

What to Do in a Currency Crisis

In a currency crisis, besides the most obvious move to reach for hard assets like gold and silver bullion, and hard currencies like dollars and euros, the best moves for Argentina-based investors and dollar-based investors are somewhat different. For those outside Argentina looking for bargains in Argentine stocks, we have not come to the end of this crisis, so it is too early to look for value in Argentine stocks.

I know it is possible to pick up companies with staying power at 25 to 50 cents on the dollar, but the volatility in Argentine assets can be so high that it is simply not worth “catching the falling knife” now, so dollar-denominated investors should stay away, as we are still very much in the contagion phase of this emerging markets crisis. It is a different emerging markets currency making negative headlines every week, which is a good indication that this dislocation in the currency markets is not over.

Argentina Stock Market versus Argentinean Peso Graph

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

On the other hand, Argentina-based investors, apart from stockpiling euros and dollars, should very much buy stocks. The Argentine benchmark Merval stock benchmark is up from 5000 to 35000 as the peso has dramatically weakened, simply because Argentine “blue chips” – if there were such a term in a country prone to serial currency crises – can reset their operations at a weaker peso exchange rate and, despite disruptions to their businesses, most will likely still be here after the latest IMF bailout; so a position in a Merval index fund is vastly superior to holding Argentine pesos in an Argentine bank.

Venezuela Stock Market versus Venezuelan Bolivar Graph

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

You can see the same dynamic playing out in a more extreme situation like Venezuela, which has been deteriorating for much longer, even before the present Federal Reserve quantitative tightening cycle started. Since it does not appear that the Fed is done, or that the Trump administration will stop its aggressive policies to rebalance the U.S. trade imbalance, I am of the opinion that we will make a fresh all-time high in the Broad Trade-Weighted U.S. Dollar Index in this cycle, which means a level above the 130.196 high registered in February of 2002. Aggressive moves both on the monetary policy and fiscal fronts in the U.S. mean that this emerging market crisis has further to go.

Broad Trade-Weighted Dollar Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Would you care to guess where the non-trade-weighted U.S. Dollar Index was in February 2002? It was near 120. Last Friday it closed at 95.13. There are numerous technical factors that make the dollar seem a lot weaker than it actually is, particularly when looking at the old-style US Dollar Index, which is not trade-weighted. Still, the rampant dollar borrowing in the past 10 years is backfiring at the moment and promises much higher values for the U.S. dollar, looking at both the trade-weighted and Dollar indexes.

Borrowing in U.S. dollars is out of control because many emerging markets (EM) borrowers assumed, erroneously, that U.S. interest rates would never rise. Well, they are rising, and such rampant borrowing is backfiring spectacularly. Emerging market debt is over $40 trillion, over half of which is China’s:

Non Financial Sector Total Debt Graph

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

As a reminder, let me repeat the point I have often made, that dollar borrowing is equal to dollar shorting. When an EM government or corporate entity borrows dollars, they sell them back for their local currency, to use as they please. Rising U.S. interest rates accelerate these dollar loan repayments and cause the exchange value of the dollar to surge, creating what is in effect a gigantic synthetic short squeeze.

And It’s not done surging.

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