Argentina’s crisis could be start of something a lot more serious
If you thought your mortgage repayments were a bit on the high side, at least you aren’t Argentinian. The central bank has just pushed interest rates all the way up to 40 per cent in an effort to support the peso and prevent capital from fleeing the country. Meanwhile, the Turkish lira has fallen to a record low, and the Russian rouble is at its weakest level in three years. The emerging markets are suddenly looking very fragile, with one country after another tumbling into a crisis.
Of course, that might just be a blip. After all, developing nations are always volatile. It could, however, be the start of something a lot more serious. Why? Because U.S. interest rates are going up, which is always bad for the developing world, any intensification of the looming trade wars is going to hit those countries worst of all, and, finally, because technology dominates many emerging market indexes. It’s a combustible mix.
No one ever expected stability from the Argentinian economy. But even by its standards, the country’s had a tough fortnight. Over the course of just a few days, interest rates were hiked from 27.5 per cent to 40 per cent as the peso plunged in value on the foreign exchange markets. As it happens, its president, Mauricio Macri, a rare Latin American Thatcherite, may well be doing a good job, scrapping subsidies and price controls, and taking down the tariff barriers that have made the country a semi-socialist backwater for years. But there is a lot of pain in the process.
It is not just Argentina, however. The Turkish lira has plunged to a record low against the dollar. Inflation has climbed to 11 per cent, the country is heading into turbulent elections in late June, and the central bank has just pushed interest rates up to 13 per cent.
Elsewhere, the Russian rouble is wobbling again. In April it dropped by 10 per cent against the dollar in a single week, taking it down to its lowest level in three years, and it was under heavy selling pressure again last week.
Investors are heading for the exit. Global funds pulled US$1.3 billion from emerging market debt last week, the equity index dropped sharply, and currencies, which are usually where the trouble really starts, fell across the board for the fifth consecutive week.
A classic emerging markets crisis runs much like a game of dominoes. One country falls after another. That was what happened in the last big storm, slightly over two decades ago. The Asian financial crisis started in Thailand in 1997, and spread right across that continent, before erupting all over again in Russia the following year. Could a similar script unfold this summer? There are three reasons to fear it might.
First, the Fed has started tightening monetary policy. The US economy is doing fine, with growth projected at 2.3 per cent and President Trump’s tax cuts stimulating demand. The trouble is, while higher rates are fine for the US, they always hit the emerging markets – which have a lot of their debt denominated in dollars – hard.
Next, trade wars will hit the emerging markets harder than anyone else. Some of Trump’s reforms are helping the U.S. economy, but his brainless imposition of tariffs and quotas are going to hurt everyone else.
Even worse, both China and the European Union seem intent on retaliating, which is only going to make matters worse. If that escalates, it is going to be bad for the whole world. But it will hit the developing economies most of all. Why? Because they typically rely on exports to fuel their growth, and especially exports of manufactured goods to the US, which is the sector most likely to be hit by tariffs.
Finally, take a look at the companies in the main emerging markets indices. Most investors in those funds might think they are buying into a broad range of industrializing countries selling goods to Western Europe and the US. In fact, they are increasingly dominated by technology. In the benchmark MSCI Emerging Markets Index, IT now accounts for 27 per cent of the weighting. Sectors such as industrials and consumer staples, which you might think were more important, only account for around 5 per cent each. It is giant companies such as the Chinese internet firm Tencent (which is worth almost $30 billion), Alibaba, Samsung and Taiwan Semiconductors that lead the index.
They are all hitting the same kind of stratospheric valuations as the U.S. tech giants such as Amazon and Netflix. Sure, many of them are excellent businesses, and over the long-term they will almost certainly do brilliantly well. But there could well be some huge falls along the way.
Tech is volatile, and emerging markets are volatile. Put the two together, and you can guarantee it is going to be a bumpy ride.
It has been a rough few years for the emerging and frontier markets. With young and increasingly educated workforces, they may have the best long-term growth potential.
But, with the exception of 2017, when they gained 37 per cent, they have missed out on the global bull market. It doesn’t look like that is about to end any time soon. One or two running into trouble might not make much difference. Argentina is not crucial to the global financial system, and neither is Turkey or even Russia.
But if they start to unravel one by one, they could be the biggest threat to the global markets over the summer – and there are already worrying signs that is precisely what is happening.