Is This Bull Run Over?

Emerging Markets

Aussie stocks bounced back strongly yesterday, and are set to open flat today, in a sign that the concern over a trade war is overdone. Perhaps Trump’s team have done their homework. Perhaps they now see that a ‘spend as much as you want’ policy in government doesn’t quite gel with ‘let’s reduce our trade deficit’.

One thing that could cause the trade deficit to grow at a slower rate is rising US interest rates. That’s based on the rationale that rising rates curbs demand for credit. Slower credit growth means less consumption. Less consumption means less imports, which — you guessed it — means a lower trade deficit.

But this is hardly going to change the structure of US consumption. As soon as you see evidence that interest rate rises are starting to bite, the Federal Reserve will stop increasing them.

The driving force of the US economy — and indeed, the global economy — is consumption of foreign goods and services with borrowed money. It’s been this way for decades. Until the system blows up, that’s the way is going to be. Perhaps for decades more to come.

So Trump and his braindead trade advisers need to move on from their mercantilist trade views. They must realise that the US is the consumer of last resort, and always will be.

That is, it always will be while the US dollar is the world’s reserve currency. While this is, on the surface at least, a pretty sweet deal, it’s also a double edged sword.

When you have the benefit of issuing a global reserve currency, it’s pretty much all or nothing. That is, you get goods and services by being able to perpetually borrow, while never having to pay it back. But this system only works while it remains in the interests of the creditors to keep extending credit.

If they decide, or are forced to no longer extend credit, the ‘all’ becomes ‘nothing’. Because if the US can’t borrow, its economy will collapse.

The good news — sort of — is that the US and its creditors are locked in a symbiotic relationship whereby the system ‘works’. Not for everyone, of course. But it works for enough people that it’s not under immediate (or even medium term) threat of anyone, or any group, throwing a spanner into it.

And more than anything, it works for the US. So Trump better not ruin the party by inciting trade wars and having some childish view that the US would be ‘strong’ if it had a trade surplus.

If he persists with this line of thinking, he might have his own ‘nightmare on Elm Street’ to contend with. Or am I just being paranoid?

Health of Emerging Markets

Regardless, a more realistic concern right now — with US interest rates rising — is the health of emerging markets. Emerging market debt has grown massively since the 2008 crisis. And the interest on that debt is starting to rise.

First, a quick explanation of how this debt came about, because it ties in with the US dollar as the world’s reserve currency.

When the US runs a trade deficit with a country, say China, the excess dollars flow into China’s economy. Normally, this would result in an appreciation of China’s currency versus the dollar. But China doesn’t want this, so it prints yuan to offset the inflow of dollars.

These yuan form the reserves of the domestic banking system. They provide a base for China’s own credit creation machine. See, US deficits are good for everyone!

Debt Begets Debt

Anyway, that’s a simplistic version of how a country that runs a trade surplus can still have lots of debt outstanding, like China does. In our magical system of finance, debt begets debt.

And emerging markets have been gorging on it. As the Financial Times reports:

‘…since the crisis, debt in emerging markets has surged. In China, it rose from 171 per cent of GDP at the end of 2008 to 295 per cent at the end of last September. The combined debts of a group of 26 large emerging markets monitored by the IIF [Institute of International Finance] rose from 148 per cent of GDP at the end of 2008 to 211 per cent last September.

The IMF and others argue that the pace of debt growth is often at least as significant as its overall level in signalling trouble ahead. Yet the rapid rise in emerging market debt to GDP during the past decade — by more than 40 per cent in the IIF’s 26 countries and by more than 70 per cent in China — has still to register with many people.

The market often doesn’t care about an issue…and then it all of a sudden cares very much. Below is a chart of the ishares MSCI Emerging Markets ETF [AMEX:EEM]. Since the 2016 low to the January 2018 high, this ETF rallied nearly 90%. The debt provided equity market with leverage. And we know leverage magnifies gains in the upswing.

iShares MSCI Emerging Markets ETF - EEM (AMEX) Daily Chart 07-03-2018

Source: Optuma
[Click to enlarge]

It also magnifies gains in the downswing. It remains to be seen if we’re entering a downswing now, or whether emerging markets are simply consolidating. In the chart above, the green lines signals support. If emerging market stocks break support, you could see some decent magnified losses.

I don’t have a view either way. I don’t know enough about emerging markets. But I do know that a 90% rise in two years is a decent return. The odds are increasing that the bull run is over.

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan

Greg Canavan

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

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