2008 COMMODITY PEAK ENDED EMERGING MARKET BOOM -- COMMODITY PRODUCERS LIKE BRAZIL AND RUSSIA HAVE BEEN WEAKEST EMERGING MARKETS -- WEAK EMERGING CURRENCIES WEIGH ON STOCKS -- LOCAL CURRENCY EMERGING BONDS FALL THE HARDEST
2008 COMMODITY PEAK ENDED EMERGING MARKET BOOM... My Monday message expressed the view that a stronger U.S. dollar during 2014 would have important ripple effects around the globe. One effect would be a stronger performance by U.S. stocks relative to foreign stocks. Another would be stronger performance by developed foreign markets (especially in Europe and Japan) versus emerging markets. A third effect would be continued underperformance by commodity markets. Today's message will show why a stronger dollar, and weaker commodities, have a more depressing effect on emerging markets. That's because a close link exists between emerging markets (many of which are commodity producers) and commodity prices. Chart 1 compares the CRB Index of 19 commodities to a ratio of Emerging Market iShares (EEM) divided by the S&P 500. Notice the tendency for both lines to trend together. Emerging markets were the world's strongest global stocks between 2002 and 2008 as commodities experienced a strong bull market (and the U.S. dollar fell). The commodity boom ended in July 2008 (when the dollar bottomed). 2008 also hurt the relative strength of emerging markets. A second commodity peak during 2011 ended emerging market leadership for good. Both asset classes have been underachievers since then.
(click to view a live version of this chart)
Chart 1
COMMODITY PRODUCERS -- BRAZIL AND RUSSIA -- ARE WORST EEM PERFORMERS... It's no coincidence that the weakest stock markets in the EEM are tied to commodities. Chart 2 compares three big emerging markets that have weighed on the EEM since 2008. While Emerging Market iShares lost 10% during those five years, three of the weakest performers have been China (FXI) (-27%), Brazil (EWZ) (-35%), and Russia (RSX) (-41%). Brazil and Russia are two of the world's largest producers of commodities, while China is the world's biggest importer. When China isn't buying, commodity producers do a lot less selling.
Chart 2
FALLING EMERGING CURRENCIES HURT THEIR STOCKS ... In addition to the negative impact from weak commodity prices, a direct link can be seen between a rising dollar and weaker emerging markets. That direct link comes from the performance of emerging currencies. Chart 3 shows a positive correlation between Emerging Market iShares (red line) and the WisdomTree Emerging Currency Fund (green line) over the last five years. The CEW includes emerging currencies from Mexico, Brazil, Chile, South Africa, Poland, Israel, Turkey, China, South Korea, Taiwan, and India. Chart 3 shows the two lines peaking together in the spring of 2011 (when the dollar rallied), and again last spring. Global investors had invested in emerging market assets in the search for higher yield. The jump in U.S. bond yields last spring reduced the appeal for those riskier foreign assets. As a result, emerging market stocks and currencies fell hard during the second half of last year and the first month of this year. At the moment, the currency fund is testing chart support along its late 2011/early 2012 lows. That's an important test. Weaker foreign currencies make emerging market stocks a lot less attractive to foreign investors. [The Turkish lira has lost 5% this year and has fallen to a record low against the dollar]. Emerging currencies will need to show more resiliency to attract money back to emerging market stocks and bonds.
(click to view a live version of this chart)
Chart 3
LOCAL CURRENCY EMERGING MARKET BONDS FALL HARDER... Emerging market bonds also had a bad 2013. There again, the impact of a stonger dollar can be seen. The green line in Chart 4 shows $USD Emerging Markets Bond iShares (EMB) falling especially hard between last May and July. The red line plots the Emerging Markets Local Currency Bond iShares (LEMB). The red line did much worse than the green line. The reason for that is the EMB (green line) is demoninated in U.S. dollars, while the LEMB (red line) is denominated in local emerging market currencies. Since last May, the dollar denominated bond fund lost -4%, while the bond fund quoted in currencies lost twice as much (-8%). A bond fund quoted in a weaker currency will usually do worse than one quoted in a stronger currency. The prospect for higher U.S. bond yields (and a stronger dollar) should continue to hurt emerging market bonds. In that scenario, however, dollar demominated bonds should suffer less than those quoted in local currencies.
(click to view a live version of this chart)
Chart 4
EEM NEEDS TO CLEAR OCTOBER HIGH WITH HELP FROM CHINA... The weekly bars in Chart 5 show the weaker performance of Emerging Market iShares (EEM) since spring 2011. A resistance trendline can be drawn over the two declining price peaks from the end of 2012 to October 2013. As I suggested on Monday, the EEM would have to clear its October intra-day peak at 43.52 to break through that resistance line and signal higher prices. That would probably require a stronger performance from some of the larger emerging markets, especially China. Chart 6 shows FTSE China iShares (FXI) slipping to the lowest level in four months (on disappointing economic news). The FXI would have to exceed its fourth quarter peak at 40.01, however, to turn its trend higher. Until that happens, relative strength trends will continue to favor developed markets.
(click to view a live version of this chart)
Chart 5
