Emerging Market Canary in the Coalmine

Friday’s trading session in the US was a strange one. The main indices finished down slightly, but commodities were smashed. Brent crude fell 3.3%. Aluminium and copper fell 2.3% and 2.2% respectively. Gold was down 1.8%.

What’s going on?

In short, the US Federal Reserve is behind the moves. The US central bank increased official interest rates last week for the second time this year. More importantly, it indicated that it sees the US economy as very strong and more interest rate rises are on the way…two more this year and possibly more than expected in 2019.

If history is any guide, the Fed will raise rates into a recession. They always do it.

In the meantime, the US dollar is the main beneficiary. That’s largely thanks to the widening interest rate differential between US rates and rates in other parts of the developed world. Although having said that, the US dollar index actually finished 0.09% lower on Friday. Its big move was on Thursday. It appears as though the commodities complex played catch up on Friday.

Let’s have a look at a chart of the Thompson Reuters/Jefferies CRB index, a major commodity price index. As you can see, prices dropped sharply on Friday. The index gapped below the 100-day moving average (red line) to close on support represented by the 2016 and 2017 highs. It will be interesting to see if this support holds in the coming days.

 

Who Loses from the Interest Rate Rise?

 

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Source: Optuma
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The big loser from the Fed’s interest rate rises and US dollar strength is the emerging market complex. Many emerging market currencies have been smashed in US dollar terms. Despite the recent weakness in commodity prices, it hasn’t been enough to offset the weakness in emerging market currencies. This means commodity prices continue to rise, causing pain and inflationary pressures in these economies.

 

 

As the Wall Street Journal reports:

For Americans, rising oil prices are threatening $3-a-gallon gasoline and pushing up prices for plane tickets. In many other parts of the world, today’s crude rally is more painful—sparking protests, gas lines and emergency subsidies to quell unrest.

That is because many consumers outside the U.S. face a double whammy when—like now—the dollar gets stronger at the same time that oil prices rise. While petroleum is produced all over the globe, when it is sold to refiners and other buyers it is almost always priced in dollars.

It is, in the words of Brazilian Finance Minister Eduardo Guardia, “a challenging external scenario.”

After Brazil’s military brought an end to a crippling strike by truck drivers over high fuel prices, Mr. Guardia called the oil rally “brutal” for his country.

Brazil is among the handful of oil-dependent countries in Latin America and Southeast Asia that have turned to costly fuel subsidies. Across swaths of Africa, higher fuel costs and weakening local currencies have hit prices for food and electronics.

 

Stress in Emerging Markets?

 

This stress in emerging market economies is starting to show up in equity markets. Below is a chart of the ishares MSCI Emerging Markets ETF [AMEX:EEM].

 

Money Morning 18-06-18-4

Source: Optuma
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In Friday’s trading session, it broke slightly below support. If emerging market stocks continue to give way in the days ahead, there is a good chance a deeper bear market could develop.

This chart is telling you that global liquidity is tightening. That’s what happens when the manager of the world’s reserve currency and supplier of liquidity, the US, raises interest rates.

It’s not impacting US equity markets noticeably…not yet anyway. But if the Fed sticks to the plan and increases rates by 25 basis points every quarter, it may not be long before the mighty Dow and S&P 500 also succumb to waning liquidity.

While commodity price falls aren’t great for Aussie resource stocks, the fact that the Aussie dollar is weak too insulates these companies from much of the damage. The Aussie dollar is back under 75 US cents, and looks vulnerable.

The big question is what is driving the falls? Is it just the interest rate differential between the two economies? Or is Aussie dollar weakness more related to what’s going on in China?

Because, as Bloomberg reports in the AFR, China is slowing getting off to a strong start to the year:

China’s central bank held off from immediately raising borrowing costs following the US Federal Reserve, a decision that came just as economic data for May showed that the economy is losing steam.

With the prospect of fresh US tariffs on Chinese exports approaching, the world’s second-largest economy is already slowing after a stronger-than expected start to 2018. A campaign to curb indebtedness at state firms and local governments, plus the effort to shrink the shadow-banking sector, are adding to a cyclical moderation in the pace of growth.

To be clear, the Chinese economy is still strong. But it’s the rate of change that is important when it comes to commodity price growth. And if the Chinese economy is slowing, that will have an impact on commodity prices given the very strong run enjoyed over the past two years.

The message here is clear. The US Federal Reserve is slowly draining excess liquidity from global markets. That makes investing during these times particularly tricky.

 

Regards,

Greg Canavan,
Editor, Crisis & Opportunity


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’. That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors. And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis. Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


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