Hutchens Investment Management - Emerging Markets Are Dangerous But Not Deadly

CONCORD, N.H. - Feb. 12, 2014 - PRLog -- Since the US financial crisis ended and the slow grinding recovery began in 2009, the assets of less developed countries has been a “risk on” trade. When Fed Chairman Bernanke announced in May 2013 that the Fed would be printing less money to buy bonds (QE), the overvalued currencies and financial assets of many of the Emerging Market (EM) countries suffered sharp declines. Stocks and bonds were dumped, but when the Fed decided in September to maintain its QE policy a while longer, inflow into these markets accelerated. A weak manufacturing number in China in January triggered the prospect of slowing growth with excessive credit. Exit the fast money. Meanwhile currency losses in the Turkish lira (-13% against the dollar), and Argentina’s peso (-20%) added to the negative backdrop. But the selloff was swift and the fears of contagion have so far subsided.

Do the risks of a contagion similar to that of 1997-1998 still remain or have they been limited? We have reason to believe that the risks have been limited. The deteriorating EM situation began in Thailand on May 14, 1997 and ended with the Russian default on August 19, 1998. Briefly stated, the policy measures eventually implemented by the IMF and the World Bank were too little, too late. Only after the Dow Jones declined a record 554 points on October 27, 1997 did the IMF accelerate the loan packages. The crisis continued, but was contained until May 1998, when the stretched Russian financial system reached the breaking point and ultimately defaulted. The experience of the US financial crisis and the near default in the EU will expedite the policy adjustments should the EM problems become widespread. Also, most EM’s are less vulnerable to a repeat of 1997-1998. Flexible exchange rates, reserves in excess of $7.7 trillion, manageable current account deficits, and overall lowered debt in most EM countries should minimize any further fallout.

In immediate response to the potential EM market crisis, the US stock market fell about 7%, and the durability of the US recovery, once again, was questioned. As everyone waited for the Employment Report last Friday, fears of a low number ignited further selling of equities. But the weak Report, with only 113,000 non-farm payroll jobs added, was quickly digested and stocks had their best back-to-back increase this year. In many ways the brief correction was based on unsound explanations, such as the market was too high, so therefore it must correct. Whether the stock market corrects further is immaterial to the fact that fundamentals underlying equities and the economy are much better than the bears would have investors believe. Earnings are stronger than anticipated, with eight of the ten major S&P 500 sectors outpacing estimates (Energy and Utilities lag). To date, according to Factset, with 344 S&P500 companies reporting, 72% have posted better-than-expected earnings with a blended growth of 8.1% for 4Q2013 compared to 4Q2012.

Our investment strategy remains long-term optimistic on corporate equities. The recent sell-off was more technical than fundamental and more short term than long term. We believe the economy in 2014 will trump the negatives as the year unfolds.

Authors:
David Minor
Rebecca Goyette

Editor:
William Hutchens, CFA