The U.S. stock markets are in a shambles.
The S&P 500, the most important indicator of the U.S. economy, was down 7.33% in October. That represents the largest decline since May 2010, when the S&P 500 fell by 8.20% as a result of the Flash Crash.
Of course, the Democrats are not complaining. They would love to see a market crash during Trump’s presidency.
We are less than a week away from mid-term elections. Polls are projecting that the Democrats have a 70% chance to win back the House. This, of course, would weaken the president’s position.
The situation has squeezed President Trump into a corner. His window to find a solution for the stock market is running out. Either sign new trade agreements… or watch the stock market burn.
New trade agreements would be great news for the American economy and undoubtedly would send stock prices way back up again…
However, the real winner if the story plays out this way would be emerging markets, which have so far this year suffered a two-pronged attack at the hands of the United States.
The Emerging Market Crisis
Since the start of 2018, the FTSE Emerging Markets Index (VWO) is down 14% for the year. It has declined 23% from its Jan. 26 highs.
From one side, emerging markets have been hit by President Trump’s effort to reign in the rising U.S. deficit by imposing trade tariffs. Tariffs increase the prices of exports from the countries in question. These countries, of course, rely on exports for their GDP growth.
From the other side, emerging markets have also been hit by the Fed’s raising of interest rates. High interest rates make U.S. dollar-denominated debt, a common type of debt in emerging markets, more expensive to maintain, applying pressure to profit margins.
If you ask me, the double-whammy attack is all part of a master plan to squeeze emerging markets into signing better trade deals with the United States.
While it looks like the strategy is proving effective, it comes at a cost.
Fears that the United States might enter a recession are spreading. If interest rate hikes don’t slow down, the Fed risks suffocating the economy.
The same will happen if the U.S. economy is no longer able to benefit from global trade.
Thus, the pressure to sign new trade agreements is rising on both sides of the conversation.
If and when new agreements are signed, it will be stocks in emerging economies, not in the United States, that will gain the most. At current valuations, some emerging market stocks are trading for pennies on the dollar.
The potential upside is big.
Why Do They Look Good?
Equity valuations in the emerging economies have been trading around multi-year lows, but it looks like the tide is finally ready to turn.
Stock markets always overreact, to both good news and bad. It is a simple function of the way our human minds work.
Today, the emerging markets are in much better condition than their stock markets indicate… as a result of perhaps one important unintended consequence of the events of the last year.
Yes, the U.S. tariffs have hurt many economies, but they also have brought them closer together. Now they know that they can’t rely solely on the United States as outlet for their exports and that they have to improve economic ties elsewhere. The enemy of my enemy is my friend…
Last week, China and Japan, two of the United States’ top trading partners, both pressured by U.S. tariffs, signed a new trade agreement with each other. Not long ago, these countries were at each other’s throats over a dispute to do with territory in the East China Sea. Now they’re trading buddies.
The historic agreement includes $18 billion in business deals and a $30 billion currency swap. This is just the beginning. I expect that the two countries will expand the agreement next year when President Xi visits Japan.
Meantime, investment capital that was flowing rapidly out of emerging bond markets toward rising U.S. yields is beginning to reverse course. Many central banks are responding to rising U.S. yields by raising their interest rates, attracting investment capital back into these countries.
Last month, the emerging market currency volatility index, which had been rising for more than a year, dropped to its lowest level since 2013. I see this as a clear sign of good things to come, given that currency devaluation was one of the two major factors behind the sell-off in emerging markets.
Another factor benefiting emerging markets is rising commodity prices. Many emerging economies continue to rely on commodity exports to drive the performance of equity markets. Reuters’ CRB core commodity index (TRJEFFCRB) is up by 24% since February 2016 lows.
Finally, I believe that emerging markets’ stock values have already priced in the effects of both the trade war and of rising interest rates. As long as those two issues don’t seriously escalate, I see no immediate threat to emerging market values.