Monthly Markets Memo - September 2018
by Dan Zalipski, CFA
U.S. Equities are putting on a one-man show posting positive returns over the past month. Various economic indicators point to continued strength in the U.S. Economy. Manufacturing activity is at a 14-year high, consumer confidence is at an 18-year high, and small and medium-sized business sentiment is at a 35-year high. Developed international markets continue to languish but were mostly unchanged from a month ago. The U.K. continues to negotiate their exit from the European Union driving some uncertainty within the region. Broader Europe appears to be coming out of an economic soft-patch that weighed down the first half of the year. Turning to fixed income, yields on treasuries had been held down by investors seeking safety from developments in the emerging markets. This reversed itself when the August jobs report revealed robust wage growth, sending treasury yields higher from 2.88% towards the 3.00% mark.
Emerging markets have been a source of turmoil for the global equity markets this summer. This past month they officially hit bear market territory, falling 20% from their January highs. Emerging markets is but a single label applied to a large asset class. The temptation to oversimplify this space is high, but developments in emerging markets require extra scrutiny to determine their potential impacts in a global portfolio. Below we discuss emerging market’s position within the global marketplace and the recent events contributing to the sell-off.
Emerging Markets are economies progressing towards becoming advanced on par with developed nations such as the U.S., the U.K., and Japan. Depending on which index you look at, a little over 20 countries are typically considered emerging markets, including recognizable names such as China, Brazil, India, Russia, and Mexico. Emerging markets contain 85% of the world’s population, 55% of the world’s energy consumption, and 57% of the world’s GDP. These countries typically have younger populations, an expanding middle class, and higher growth rates than their developed counterparts. These characteristics are significant, warranting an allocation to the space in investment portfolios seeking global equity exposure, but investors need to recognize the growing pains these economies experience.
Emerging economies tend to be more volatile for reasons ranging from economic in nature to political. Argentina is one country currently struggling. They had indicated they would gradually depreciate their currency over several years as it was generally considered to be overvalued. Investors lost confidence that the Argentine government can control inflation, and the gradual depreciation aggressively accelerated out of control. Inflation historically runs high in Argentina, making their economy sensitive and vulnerable to changes in its currency. As the currency weakened, inflation spiked, and economic activity plummeted. The country received a $50B loan from the International Monetary Fund to help put a floor into the currency’s free fall. At the same time, Argentina’s central bank raised interest rates to an eye-popping 60% in an effort to contain the inflation. Moves like these can be painful for an economy but prevent a dire situation from escalating into something worse.
Another country making headlines this summer was Turkey. Like Argentina, Turkey is grappling with a substantial and rapid decline in the value of their currency and high inflation. Foreign investors have lost confidence in the country’s ability to pay their debts. Analysts agree the solution to Turkey is easy: have the central bank increase interest rates. Enter politics. Turkey’s President Erdogan recently consolidated power within the country, eliminating the role of prime minister and giving himself the authority to hire and fire essentially any government position. President Erdogan believes higher interest rates will lead to higher inflation, a position the global economic community vehemently disagrees with. Due to his position of power, and appointing his son-in-law as their minister of finance, Erdogan has compromised their central bank’s independence, influencing the institution to keep interest rates low, prolonging the crisis. In addition to all of this, Turkey is exchanging trade war volleys with the U.S. over Turkey’s detainment of an American pastor accused of being part of 2016’s attempted coup. There may be signs, however, that the pain is becoming too much to bear, as the central bank broke ranks and raised interest rates to 24% in September. Additional hikes or a broader intervention may be needed should the crisis continue.
These two examples, in addition to the ongoing trade war with China, have contributed to the space slipping into bear market territory (bear markets are defined as a 20% decline from recent highs). Outside of these examples, the rest of emerging markets remain fundamentally strong on a relative basis. When a handful of isolated, country-specific events can help drive the entire space down, it creates an environment where active managers can add value. These managers seek opportunities, buying at low points to capitalize when the space regains its footing. Despite the volatile market action within Emerging Markets, we believe continued exposure to the space is appropriate for a portion of equity portfolios, and that a skilled active manager has the greatest potential to produce meaningful returns.
"Cash combined with courage in a crisis is priceless." - Warren Buffet
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