The Future for Emerging Markets

Laura Tyson

JUN 30, 2015

bright future

BERKELEY – Over the past year, the global economic environment changed markedly and in unexpected ways. Energy and commodity prices plunged. Growth in China (which accounts for about 40% of global growth) fell to its lowest rate since 1996, even as its stock market soared to unsustainable heights. The United States and the European Union ratcheted up economic sanctions on Russia in response to its military excursions in Ukraine, highlighting the geopolitical risks associated with cross-border investments. And there have been large swings in exchange rates, fueled by actual or, in the case of the Federal Reserve, anticipated changes in monetary policy.
These rapid changes have rattled global financial markets and spooked investors, reducing their appetite for risk – a cautious attitude that has been reflected in emerging markets. Investors have sat on the sidelines, and the MSCI index that tracks returns on emerging-market equities has stagnated.
During the second half of last year, the 15 largest emerging-market economies experienced the biggest capital outflows since the 2008 global financial crisis. And the aggregate foreign-exchange reserves held by emerging countries declined for the first time since 1994, when they began the steep upward climb that has been a defining feature of the global economy during the last two decades.
One major factor driving the lackluster performance of investments in emerging markets is the expectation that the Fed will begin to raise interest rates and normalize monetary policy later this year. In a recent speech, Fed Chair Janet Yellen confirmed that such steps would be “appropriate” if the economy continues to improve, stating that “delaying action to tighten monetary policy until employment and inflation are already back to our objectives would risk overheating the economy.”
Expectations of a rate hike have restricted flows to emerging markets ever since 2013, when the Fed triggered what came to be called the “taper tantrum” by announcing that it was likely to reduce its bond-buying program. The resulting alarm roiled US financial markets and spilled over internationally. Emerging-market economies came under intense pressure, with inflows to investment funds falling sharply, asset prices declining, and many currencies losing value against the dollar.
Fortunately, the worst of the taper tantrum proved temporary. Capital inflows recovered somewhat, and most emerging-market economies weathered the financial distress in their capital markets. But the experience raised questions about the effects of future moves by the Fed. Stanley Fischer, the Fed’s vice chairman, said recently that he expects the anticipated increase in the Fed’s policy interest rate later this year to “prove manageable” for emerging-market economies. But sudden steep declines in foreign capital inflows triggered by the Fed’s action could exacerbate the challenges that even the best-performing Asian economies are facing, as anemic demand in their export markets causes growth to slow.
The Fed has tried hard to be very clear about its policy intentions, strategies, and timing to ensure that investors are not surprised. In recent years, assets in emerging-market economies – especially currencies – have depreciated by 5-50% relative to the dollar, reflecting both external imbalances and the broader macro conditions of individual countries. There is a widespread view that most emerging financial markets have already priced in the effects of a gradual increase in interest rates. But that does not mean that these effects will be insignificant for countries that investors already regard as risky.
As investors have become more cautious, they have also become more discriminating. The difference in returns across emerging countries and among sectors within them has grown. The countries at greatest risk of large capital outflows include those that are dependent on external financing, those with commodity-heavy economies, and those with uncertain political conditions.
Many of the best performers are in Asia – the only region where several economies have grown by 5% or more for at least four decades. Over the last year, the MSCI index for Asia increased by 10%, even as it fell by roughly 14% for emerging and frontier markets and by 21% for emerging markets in Latin America. And, indeed, Asia’s two largest emerging economies offer reasons for cautious optimism.
China is certainly not free from risk. The recent equity-market rally is largely divorced from fundamentals and is driven by speculative, debt-financed purchases. The outlook for corporate profits remains weak; the country’s equity supply is growing; and valuations are stretched. Up to 10% of China’s equity market cap is funded by credit – five times the average in developed economies.
But China also has substantial wriggle room in its monetary and fiscal policy to contain the adverse consequences of its debt buildup, real-estate boom, and irrationally exuberant stock market, while simultaneously pursuing bold structural reforms in its economy and capital markets. China’s growth rate may have dropped from a three-decade average of 10% to a 25-year low of 7%, but that slowdown has been largely the result of policies to reduce fixed investment and move the economy from manufacturing to services. Employment remains strong, and the middle class is growing rapidly.
Meanwhile, in India, the implementation of Prime Minister Narendra Modi’s ambitious reform agenda has been slower than anticipated. But inflation is down; the fiscal situation has improved; and the economy has benefitted from the drop in oil and commodity prices. Growth of 6-7% seems achievable, and Modi remains a popular reform-minded leader whose policies are attracting the support of domestic investors.
As global investors navigate the uncertain waters of emerging markets in the next few years, they should remember that, for these economies, the wave of industrialization and urbanization and the associated productivity gains are far from over. With their faster-growing populations and productivity, they will enjoy a growth advantage over developed economies for some time to come.

The Wizard of Oz and the Case for a Later Liftoff

Tony Sagami

June 30, 2015

The last time the Federal Reserve raised interest rates was way back in June of 2006.

Moreover, the Fed has kept interest rates near 0% since 2008.

But after the June 17 FOMC meeting, just about everybody—and I mean everybody—is assuming that the Federal Reserve will raise interest rates later this year.

The Fed has been so convincing that the market sees a 34% probability for a rate hike by September and an overwhelming 88% probability for a rate hike before or in December.

Heck, even Fed Chairperson Janet Yellen has said that she expects the Fed to raise rates in 2015.

Frankly, I don’t trust the Fed to do anything right, so my prediction is that Janet Yellen and her Fed buddies should not and will not raise interest rates this year.

Hey, I’m not the only person who thinks so.

The International Monetary Fund (IMF) says the FOMC better not raise interest rates this year. The IMF urged the Federal Reserve to delay a rate increase because of a still-struggling US economy and warned of “significant uncertainties as to the future resilience of economic growth.”

IMF Chairperson Christine Lagarde didn’t pull any punches:

“Higher US policy rates could still result in a significant and abrupt rebalancing of international portfolios with market volatility and financial stability consequences that go well beyond US borders.”

“Asset price volatility could last more than just a few days and have larger-than-anticipated negative effects on financial conditions, growth, labor markets, and inflation outcomes.”

“We think that there is a case for waiting to raise rates until there are more tangible signs of wage or price inflation than are currently evident. So, in other words, we believe that a rate hike would be better off in early 2016.”

The IMF sees a very different world than the Federal Reserve, though.

Fed-Speak: The Fed reiterated in its most recent policy statement that it needs to be “reasonably confident” that inflation will move back up to the Fed’s 2% target.

IMF-Speak: The IMF said it doesn’t see inflation reaching that level until mid-2017. Given the “significant uncertainty around inflation prospects, the degree of slack and the neutral policy rate, there is a strong case for waiting to raise rates until there are more tangible signs of wage or price inflation.”

Fed-Speak: Yellen and other Fed officials have been clear that the timing of the first increase is less important than the promise that any rate increases will be shallow.

IMF-Speak: The IMF warned that a rate increase could trigger “significant and abrupt rebalancing of international portfolios with market volatility and financial stability… asset price volatility could last more than just a few days and have larger-than-anticipated negative effects.”

The IMF’s comments are very unusual because they include a precise recommendation about a very important US policy measure, but also because the IMF is poking its nose where it doesn’t belong.

It was bad enough when the United Nations tried to dictate US foreign policy, and now the IMF is trying to influence US monetary policy.

My advice to the IMF and United Nations? Butt out!

However, the IMF is closer to being right than Janet Yellen because our economy is far from healthy.

The Commerce Department revised first-quarter GDP numbers to a negative 0.7%, and consumer spending was up a sluggish 1.8% during the same time frame.

Those weak numbers prompted both the IMF and the Organization for Economic Cooperation and Development (OECD) to lower their growth estimates for the US economy.

·         The IMF lowered its 2015 GDP growth forecast from 3.1% to 2.5% last week.

  • The OECD has slashed its US growth forecast from 3.1% to 2% for 2015.

  • Even the Federal Reserve turned more cautious, lowering its growth forecast from 3% to a range of 2.3% – 2.7% in March.

So what’s the Federal Reserve going to do?

Perhaps the Fed has painted itself into such a tight corner with all its tough talk that it has no choice but to raise interest rates before the end of this year.

If that’s the case, however, I expect the FOMC to raise interest rates by so little that it may feel like a mosquito bite. I’m talking about a 5 to 10 basis point increase.

The reason is simple: The US dollar has risen by more than 20% against both the euro and the Japanese yen since June 30, 2014 and the IMF has warned that further appreciation of the dollar would be harmful to the US economy.

The US trade deficit soared to $51 billion, its widest gap since 2008, because the strong dollar made US exports more expensive. Exports fell by 14%, the largest decline in six years.

This bulging trade deficit is the main reason that the US economy shrank by 0.7% in the first quarter.

The Fed hasn’t admitted such, but it understands that a rate increase would push the US dollar even higher and create more of the same trade deficit-induced drag on our economy.

That is why we won’t see anything other than a tiny, tiny face-saving rate increase… or nothing at all.

My advice is to pay no attention to the lady (come on, you got to admit that Janet Yellen sort of looks like the Wizard of Oz from the backside) behind the Federal Reserve curtain. Her tough interest rate talk is all false bluster and misdirection.

If you’re an income-focused investor, you should take the Washington Post’s advice and realize that the rules of successful income investing have changed.

And that you need to change too… unless you can survive on 0.5% interest rates.

I just recommended a stock to my Yield Shark subscribers that’s the epitome of “doing something smart.” It’s paying a 2% dividend right now—not all that exciting, you might say…

BUT its dividends have risen so consistently that had you bought shares 15 years ago, your “dividend on acquisition” (i.e., today’s dividends as a percentage of what you actually paid for the stock) would now be an astonishing 14.6% per year.

Combine equity appreciation and dividends, and you end up with a total return of 502.97% over 15 years. Not too shabby, if you ask me.

This is a company with an in-demand product that’s doing everything right, and you can get it at a great price right now. So if you’re looking for both high yield and share price appreciation, this is a good place to start.

Greek Default Deals Blow to IMF

Economists point to fund’s missteps in 2010 Greek bailout plan

By Ian Talley

Failure to pay the $1.7 billion due to the IMF, a record overdue obligation, puts Greece in a small group of mostly conflict-ravaged debtors that have stiffed the IMF. Photo: simela pantzartzi/European Pressphoto Agency
Greece became the first advanced economy in the seven-decade history of International Monetary Fund to default on its loan payments, marking a significant setback for both for the country and the world’s emergency lender.

Failure to pay the $1.7 billion due to the IMF, a record overdue obligation, puts Greece in a small group of mostly conflict-ravaged debtors that have stiffed the IMF, a short list that includes Afghanistan’s Taliban and coup-stricken Haiti. Zimbabwe was the IMF’s last major defaulter in 2001.

The default to the IMF sent a warning signal to Greece’s other creditors, including domestic Greek institutions such as pension funds and federal employees.

In ascribing blame for the default, however, many economists point in part to missteps by the fund itself when it helped craft a €110 billion joint bailout package in 2010. Critics highlight the IMF’s failure to demand Greece embark on an immediate debt restructuring and its reliance on far-too-optimistic growth forecasts.

“The entire Greek saga since 2010 has been hugely damaging to the IMF’s reputation,” said Ajai Chopra, a visiting fellow at the Peterson Institute for International Economics and a former deputy director of the IMF’s European Department.

Joseph Stiglitz, a Columbia University professor and former World Bank chief economist, said the IMF’s missteps with Greece would likely make countries think twice about seeking assistance from the fund. He notes how the fund’s austerity focus in the Asian crisis of the late 1990s spurred many emerging markets to build up their foreign currency reserves as emergency-financing insurance.

“Turning over their sovereignty to the IMF is seen as an extraordinary risk,” Mr. Stiglitz said, “especially when you do such a bad job of forecasting.”

Officials from the IMF and the U. S.—the fund’s largest single shareholder—lay the blame squarely on Greece’s failure to deliver on promised economic overhauls. The bailout, they say, gave Greece space to restructure its economy while allowing Europe time to develop financial backstops and the global economy room to recover.

But Mr. Chopra, the chief architect of the IMF’s bailout of Ireland, said Greece’s creditors, including the IMF, are also culpable for the bailout’s failure.

By many accounts, the first program negotiated in 2010 between Athens, the eurozone and the IMF set the country up to stumble.

According to confidential IMF documents reviewed by The Wall Street Journal, some IMF staff and nearly a third of the board’s executive directors raised objections at the time to the bailout’s design.

Some executive directors warned the growth projections were unrealistic. Others stressed that a debt restructuring was needed to soften the impact of the deep budget adjustments and tough economic overhauls.

But under pressure by the fund’s largest shareholders—the U.S. and Europe—the fund moved forward amid fears that a meltdown in Greece could spread across Europe.

The IMF’s decision not to press for debt restructuring in 2010 “was the original sin,” said Alessandro Leipold, chief economist for the Brussels-based think tank, the Lisbon Council.

The fund eventually did require a restructuring of a hefty portion of Greece’s debt in 2012. But by then, much of the damage was already done. Greece failed to meet the IMF’s forecast for a return to growth in 2012. In fact, the economy shrank by 25% over four years.

Rather than helping cut Greece’s debt—as it does in many other programs—the fund-designed bailout package sent the nation’s debt skyrocketing even as the government moved to cut spending. On top of that, the IMF also underestimated the effects of budget belt-tightening on Greece and other eurozone countries.

The bigger debt load required more budget cuts and economic overhauls from Greece. As the years progressed, bailout fatigue set in and the program progressively chewed through several different governments. Political turmoil in Athens complicated the government’s efforts to deliver on many of the most important economic reforms. Unemployment shot up to 28%, the economy fell deeper and deeper into recession.

Greece would have needed to secure more bailout cash—its third emergency financing program in five years—from the eurozone to pay back the IMF.

Many analysts now expect that the only thing that will allow months of gridlocked bailout negotiations to move forward is another change in government, a fate that could become reality if voters back an emergency referendum Sunday on whether to accept creditor requirements for another round of tough economic overhauls.

My Second Half Predictions - Part I

by: Bret Jensen            

  • Tuesday is the last day of trading in the first half of 2015. Stocks are going out with a bang as major indices had their worst day of year yesterday.
  • Today we take a look ahead in a two part series on some of the likely themes for the second half of the year that investors should focus on.
  • In addition, I offer some stocks and sectors that should outperform the overall market in the second half of 2015.
Today is the last trading day for the first half of 2015. Equities continue to trade in a historically narrow trading range as they have had for most of 2015. After yesterday's trading debacle, the Dow Jones has gone negative for the year and the S&P 500 is clinging to minuscule gains after a big sell-off to start the trading week. This is hardly the robust returns investors have come to expect during this rally which has ran for over six years now.

Given it is the last trading day of the first half of the year, it is time to look forward to the second half of 2015 and what it might bring for investors. In a two part series, I try to put down my outlook for the market over the next six months and offer up some stocks and sectors that should outperform the overall market through yearend.

No Equity Breakout In Third Quarter:

My first prediction is that the market will not move decisively higher from the historically narrow trading range it has been stuck in throughout 2015. While a pullback of five to 10% percent is a distinct possibility over the summer as I noted yesterday, I see no catalysts that would drive stocks significantly higher from here at least through the third quarter. This is the reason for my cautious tone on the market over the past few months both here and on Real Money Pro.

I believe three things need to happen before the market is free to explore higher levels. First, investors need to be reassured that equities can withstand an interest rate hike from the Federal Reserve. With our economy and jobs markets improving, I am really hoping that the Federal Reserve finally pulls the trigger and delivers its first interest rate increase since 2006. We can then quit playing this endless guessing game on when the central bank will finally signal they have confidence enough in our economic fundamentals to make this incremental move.

Hopefully, the markets can absorb this minor hike without much disruption which also would be a positive.

Second, whatever solution that is in the offing around Greece must take hold. Either Greece needs to be kicked out of the European Union or they need to fully implement labor and structural reforms that allow the country to compete and start to grow again. After five years of doing neither to any significant impact, some sort of course needs to be set and adhered to. This should prevent the back and forth intermittent crisis mode Europe and the global markets have had to sporadically endure over recent years.

(click to enlarge)

Finally, domestic growth needs to accelerate again. The economy in the first quarter was roughly flat and earnings growth from the S&P 500 was nothing to write home about. The economy seems on the mend in the second quarter. Although it appears full year GDP growth will once again come in with the same anemic 2% to 2.5% the economy has been stuck in throughout this weakest post war recovery on record; we should see ~3% GDP growth through the last three quarters of the year on average. This should bolster earnings growth and start to provide a tailwind to the market.

Housing Market Will Outperform in the 2nd half:

The housing market is looking up. Monthly pending home sales just hit their highest levels since April 2006 and existing home sales have been up for eight straight months and are up just over nine percent year to date. Strong job growth, improving consumer confidence, historically low mortgage rates and loosening credit should all help to ensure increasing activity in the months and years ahead.

This would be a much needed tailwind for the economy.

(click to enlarge)

Housing starts have ran around 1.5 million annually over the past three decades and got up north of 2 million annually during the recent housing boom. Housing starts have run under 1 million annually since the financial crisis and its aftermath until recently. With over 20 million more people in the country than before the financial crisis, there should be years of pent up demand to support higher levels of activity.

This is a major theme I have been playing in my Small Cap Gems portfolio where all seven of my housing and construction stocks were up in June even in a down month for the market. I recently published a piece in Investors Alley that details some good picks in this sector.

Financials Should Outperform For The 2nd Half:

Although we have seen some "flight to safety" action early this week that have brought down yields in both the United States and Germany thanks to Greece; the trend of interest rates is gradually up.

The ten year domestic treasury yield hit almost 2.5% last week; its high for 2015 before Greece reared up its ugly head once again. I believe once we get past this latest blip of volatility, interest rates will start to glide higher ahead of the Federal Reserve's first interest rate hike in almost a decade sometime later this year.

Rising interest rates helps net interest margins at banks and buoys investment performance at portfolios held by insurance companies. Many large insurers and major banks are going for 10-12 times forward earnings. This is a substantial discount to the overall market multiple and many of these financials pay decent dividends as well. As a result, I believe financials will continue to outperform the overall market in the second half of 2015.

Tomorrow we will look at some more macro trends that should play out in the second half of the year as well as some stocks and sectors that should benefit. Until then, Happy Hunting.