Emerging Markets – Emerging Risk

Large investment funds typically diversify with various categories of domestic stock groups – small cap, growth, healthcare, value…, as well as fixed income, alternative commodity fun and emerging markets.

Emerging market exposure is wise – long term

Today unique uncertainties revolve around a brave new world of “money for nothin’ and debt for free” (to misquote Dire Straits). This is a global cash reserve creation policy backed by paper confidence.

This money printing – debt for free policy – enabled by Quantitative Easing (QE) initially shifts credit flows to emerging markets (EM’s) in search of higher risk/return (2009-2011) and appreciates their currencies, stock markets and economies. QE is the 1st world countries policy of printing money by borrowing from themselves to purchase all forms of Government debt (bonds) thus supplying excess cash to banks reducing interest rates by mopping up the supply of bonds.  Fewer bonds allow rates to fall and our mortgages to become cheap. As the debt default risk subsides (>2011 in Europe) Central Banks then taper or reverse money creation and emerging markets suffer credit outflows and economic stagnation as has occurred since 2011. This reversal shifts credit flows back into host countries such as the US where safety is assured. Or credit is destroyed as QE is reversed  selling debt into the marketplace to dry up cash that might be used for expansion as in Europe post 2011. Such a reversal hurts everyone except the US.

The EM’s have an enormous positive demographic population boom that in large part has been financed with credit flows unintentionally encouraged by our Fed & central banks that have cudgeled money/investors/bankers to seek more risk and private credit creation to maximize leverage. But now this has reversed and EM’s will struggle until Europe and the US can sustain higher growth rates generating excess liquidity for riskier investments abroad or print QE money at an even faster pace.

To date the private markets have been mostly on the sidelines

Thankfully for Central Bankers Emerging Markets (EM’s) have not panicked over money printing/debt creation by our Global financial leaders and Governments.

After the 1700’s South Seas Bubble era Sir Isaac Newton at nearly 60 years of age was asked about the apparent catastrophe of the government’s money creation scheme and responded by saying that “I can calculate the movement of the stars but not the madness of men.” He died soon thereafter. Who knows how this modern QE money creation experiment will end, but the risk level will remain high and the odds of the Central Banks selling all their QE debt back onto the markets will remain a threat for years.

The madness Newton referred to was the rather blatant acceptance by government and its citizen investors, that they had discovered the key to perpetual prosperity: “essentially free” debt financing.

A foolish bet in the long run.

Emerging market currencies had been appreciating

Along with their comparative labor costs and a reduction in their export machine Emerging market demographics and middle class prosperity are the primary fuel source for future world growth, but credit flow risk is rising.

US, Europe and Japan have been sending over a Trillion dollars of credit to finance emerging markets with the free money created by central banks.

As US, Europe and Japan experience stronger economic growth and wage inflation then QE money creation will cease and reverse which will mark the final leg lower in foreign currencies Once Europe, US and China finally get in sync with normalized growth then EM’s will accelerate faster than 1st world countries and their currencies will then start appreciating once again.

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