"It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress." Sound Familiar? It was Greenspan back on 4 September 1998, when the United States economy was quite robust while the Asian Financial Crisis was taking hold. Then Chairman Greenspan was about to stave off the "stress" emerging markets were experiencing by lowering interest rates in the United States. This turned out to be rocket fuel for the US economy. This acceleration was one of the keys that would eventually become the Dot Com Era. Just as before, the likelihood of the Federal Reserve having to make policy changes due to emerging markets, instead of looking at the US economy with blinders, is quite possible. If history repeats itself, then the US economy and by extension, the stock market will soar because of this. This is good news for those who love bad news. Argentina, Turkey, Brazil, Russia, and China may push the hand of the Federal Reserve, and the stock market may very well love it - up to a certain point, of course. The Dot Com Era would eventually turn into the Dot Com Bubble, which eventually burst. You have to be careful of what you wish for... it just might come true.
Backdrop of 1998
It was June of 1997 that the Thai baht, Thailand's currency, collapsed. This triggered a 1.5-year meltdown in other currencies, dubbed the Asian Financial Crisis.
the Thai government was forced to float the baht due to lack of foreign currency to support its currency peg to the U.S. dollar. At the time, Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency.
There were a few factors that contributed to Thailand's financial crisis:
- High rate of government deficit spending
- Heavy indebtedness of companies and the government to overseas investors (Specifically, dollar-denominated debt)
- Negative Current Account Balance
- Slowing economy
- The Federal Reserve increasing interest rates in the United States due to an expanding economy and inflation (thereby creating a carry differential that favored the US dollar over Thailand's baht)
While there were other factors associated with the Thailand's economic disposition, these were some of the biggest and the ones that triggered the devaluation of the currency. This sent the US dollar up sharply versus the Thai baht:
At the time, the dollar was fetching 24.1 bahts. The peak of this spike pushed the dollar to more than double; over 57 USDTHB. What happened was the government was running a high budget deficit and the country was running a high current account deficit, as these two charts show:
At the same time, the country had a peg of the baht to the USD. Here's how that played out. If a country runs an account deficit, importing more than it exports, then the currency would be pressured downward. The reason why is that too many companies/individuals would be holding on to Thai baht because the country does not have a balance of trade. At the same time, the government had been borrowing from outside in order to pay for its own deficit. The money borrowed was denominated in foreign currency. This, too, put a drag on the Thai baht. However, the government was pegging the baht to the US dollar. Because of the pressure of the twin deficits, in order to maintain the peg, the government sold foreign reserves their central bank had on hand in order to prop up the currency.
The Thailand Central Bank ran out of foreign reserves. There was no way the government could afford to maintain the currency peg, so the central bank was forced to let the currency float freely in the open market. The baht fell sharply. This made paying back money borrowed in US dollars more expensive for the government and businesses to repay loans. Fearing massive default on loans, the markets sold off government and business debt and then sold off the baht, placing their assets in relative safety outside of Thailand. The act of selling a bond instrument pushes down price and pushes up interest rates, the inverse relationship between the two. This exacerbates the situation because debt instruments were now being priced at higher interest rates, including government debt and therefore, more expensive to pay back. So, investors sold off more debt and exited the currency, sending the currency even lower... which creates a vicious feedback loop.
This ailment in Thailand created a contagion as neighboring countries were deemed a risk as well; their debt instruments and currency were sold off. These countries: Malaysia, Singapore, Philippines, Indonesia, and Korea all saw significant depreciation in their currency along with reciprocal increases in interest rates. This contagion would be called the Asian Financial Crisis.
Eventually, the United States Federal Reserve, then chaired by Alan Greenspan, lowered interest rates in the United States; the Fed lowered interest rates by 75 basis points from September to November of that year. This made interest rate differentials less favorable in the United States. Lower interest rates, of course, act as a stimulus for the economy in the United States. This all began in 1997. This was the beginning of the Dot Com era and the economy in the United States boomed. On the day of the "Oasis of Prosperity" speech, the stock market had, at that time, its greatest one day rally in history.
A Look at Today's Emerging Markets
Where are the "hot spots" of the new emerging markets and what does their economic situation have in common with yesteryear's economy? As it turns out, quite a lot. The question is, is that good news or bad news?
The United States is currently enjoying robust economic growth. Here is a breakdown of the economy:
- 4.20% GDP Growth Rate
- 3.90% Unemployment Rate
- 2.70% Inflation Rate
- 2.25% Interest Rate
After years of near-zero interest rates, the United States economy is not only expanding on firm footing it is expanding enough to push inflation above target levels. I have said that I believe the Federal Reserve is behind the curve; I believe interest rates need to move higher faster. But, I also believe the laws of physics apply nearly everywhere, especially this law: For every action, there is an equal and opposite reaction. If interest rates move up too high, it could kill the economy. Still, I believe the interest rate levels are too low, with an appreciation of caution.
Despite that, interest rates moving higher in the United States are having ripple effects around the world. The tightening interest rates here in America mean higher interest rates elsewhere. As US interest rates increase, the differential narrows and investors will sell their foreign investments in favor of the United States. This creates a burden on these emerging economies as investors begin to sell these assets and then sell the respective currency. Central banks around the world respond by raising their own interest rates. This means that it costs more to pay debt. Most often because of negative current accounts and government deficits, these countries have to borrow from foreigners and those funds are usually denominated in the world's reserve currency: the US dollar.
And, sure enough, that is the exact playbook that is happening around the world. Factor in some government instability and the makings of 1998 all over again start to play out. There are a few countries that are concerning: Turkey, Argentina, Brazil, and Russia.
Let's start with Turkey.
Here is their economic breakdown:
- 0.90% GDP Growth Rate
- 10.2% Unemployment Rate
- 24.52% Inflation Rate
- 24.00% Interest Rate
- -$1,750 Million Current Account (month of August)
- 5.5% Government Deficit to GDP
Erdogan, Turkey's president, has helped guide the country to expansion of some 60% in 15 years. However, he hates interest rates and thinks it is a method of exploration:
(Erdogan) thought it necessary to both urge the country's banks to lend more money to fuel its expansion, while simultaneously calling for the central bank to cut interest rates in order to make the loans more attractive.
These policies, while being ultra-stimulative for the economy, have led to high inflation rates. And, now that interest rates in the United States are moving higher, investors, fearing that Turkey may not do what is necessary to stave ultra-high inflation rates, are selling their investments in Turkey and repatriating these funds back to their respective countries. This, ultimately, creates the viscous feedback loop described above. And, here is what has happened to the currency over the past several years in response to these economic conditions:
Argentina is not much better, if not worse:
Here is their economic breakdown:
- -4.0% GDP Growth Rate
- 9.6% Unemployment Rate
- 34.4% Inflation Rate
- 60.0% Interest Rate
- -$8,292 Million Current Account (Month of August)
- -3.9% Government Deficit to GDP
Just like Turkey, Argentina is getting their currency sold hard. Very hard. This is in response to economic events in Argentina as well as interest rates in the United States heading higher. The outcome continues to create a vicious feedback for the country, and by extension, its economic indicators such as the currency and stock market.
With Argentina, there is an event that occurred that no government could have prevented, that being a very severe drought. Prior to 2017, the economy in Argentina was robust. Then, the drought and deep recession from that turned everything around. This exposed weaknesses of the economic policies of Argentina's previous government administration. On some level, I feel bad about the drought; A government cannot prevent a drought. But, a government can take on good governance and not drive up heavy deficits by spending beyond its means, something that Argentina appears to repeat over and over again.
Investors have fled en masse out of the Argentinian peso. But, at least this time, unlike the collapse of their currency in the late 1990s, there is an alternative that Argentinians are embracing fanatically, that being Bitcoin.
In the meantime, the country has had to respond to the selling of the peso. Interest rates are the highest in the world at a mouth-dropping 60%. This has sent up borrowing costs for businesses and so investors have fled for safer investments in other parts of the world. And, here is a look at the drop in the currency:
Brazil in the hot seat
Here is their economic breakdown:
- 0.20% GDP Growth Rate
- 12.1% Unemployment Rate
- 4.19% Inflation Rate
- 6.5% Interest Rate
- -$717 Million Current Account (Month of August)
- -7.8% Government Deficit to GDP
Brazil is another country that has seen its currency sell off, and, at the time of this writing, I believe it is going to get worse very quickly. The Presidential election is on the 7th of this month. No one is supportive of the #1 and #2 candidates that have emerged amid the biggest political scandals in Brazil's history. The markets are already fatigued from the previous recession and the falling currency. The lack of trust in the system and the fact that neither of the candidates are really putting forth economic reform that will push the economy forward will very likely result in more selling of the currency.
Even prior to this, Brazil was reeling from a recession that began in 2014 and led to the impeachment of President Rousseff. The economy had not seen an increase in GDP growth until the first quarter of 2017. The currency is back down 25% from its recent highs to the lows experience during the worst part of its economic crisis from previous. This is during a growth period in Brazil and while the punch bowl in America is being taken away with interest rates heading higher. Factor in that Brazil has a steep government deficit, are running a current account deficit, interest rates are relatively high and with the decline of the real, Brazil is shaping up to have a unique kind of economic crisis.
Russia and China
To a lesser extent, Russia and China may contribute to the future economic malaise that is occurring around the world. However, there are two points to make for Russia and China that are bright spots: First, both countries do not borrow heavily from overseas. Therefore, they are not susceptible to concerns of repaying loans denominated in US dollars despite the large drop in their respective currency. At the same time, Russia does not run a budget deficit but has a surplus; a huge plus. (Note: There are other concerns that China faces that I will address that deserves a separate article). Despite this, both countries have seen their currency sell off for different reasons and a subsequent inflation increase from that. I believe their role will be more of a casualty in this economic crisis, but not necessarily contributors such as Turkey, Argentina, and Brazil. Eventually, I believe I will be writing about them in subsequent follow-up articles because that "casualty" status may turn into something bigger.
How the interest rate scenario plays out
As interest rates increase in the United States, money is flowing out of emerging markets back to the United States; the interest rate differential is narrowing. This pushes down the respective currency versus the US Dollar as investors leave sell their investments in that country. The fact that these countries have been running large government deficits and large current account deficits exasperates the problems that plague these economies. This is inflationary and forces the central banks of the respective countries to raise interest rates. This creates a vicious feedback as the higher borrowing costs, lower currency purchasing power, and deficits exacerbate the economic frailties of each country. All the while, America is seeing a robust economic expansion.
What does the Federal Reserve do about interest rates here in America? Great question. I have outlined exterior factors that the Fed needs to keep in mind. At some point, these outlying factors are going to get worse and worse as more and more countries fall into their own malaise. This will ultimately push the hand of the Federal Reserve. I believe the Fed is going to have to take into consideration its policies and their effects around the world, just as Greenspan did in 1998. This means that there is the probability that the Fed will slow down its interest rate increases. That will be a big positive for the US equity markets.
At the same time, I believe there is a debt bubble. If the Fed does not reign in interest rates it risks exasperating that bubble by allowing it to continue. However, any large increases may pressure the bubble and break it. If that Bubble Bursts, it is going to make the housing bubble of 2008 look silly in comparison. The Fed has a lot on its plate to keep balanced.
In the meantime, if the Federal Reserve acts to stave off concerns from overseas, this could fuel the economy in the United States even further. That would be good... until, of course, that bubble gets burst just like the Dot Com Bubble. If this plays out as I have described, just keep in mind that there is a party ahead, but at some point, someone is going to take away the punch bowl. Then what?
Disclosure: I am/we are long SPY.
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.