Friday, June 19, 2009

Emerging markets stage a dramatic comeback

The year 2002 was the worst of times for emerging market economies. Argentina devalued its peso by over two-thirds and then defaulted on over $100 billion of debt. Commodity prices were extremely low. Since then most emerging market economies have come roaring back. As the first chart shows, an investment in the Brazilian stock market in 2002 has produced a return, measured in dollars, of over 1000%. As the second chart shows, about half that return is due to a dramatic appreciation of the Brazilian currency.

Looking behind the scenes, the big thing that drove emerging markets down in the early 2000s was deflationary monetary policy in the U.S. The dollar hit a high in 2002, thanks to very tight monetary policy from 1996-2001; the world was starved for dollars. Commodity prices were extremely depressed because of the strong dollar; the world preferred dollars and dollar bonds to commodities. Gold presaged the deflation, hitting a low of $255/oz in early 2001.

Since then the dollar has plunged and commodity prices have soared. Instead of a shortage of money, the world is awash in cash. Interest rates everywhere are extraordinarily low. This is nirvana for most emerging market economies, since they are typically important commodity producers and most have large debt burdens (with the notable exception of Chile, which has virtually no debt and a huge sovereign wealth fund). Easy money is a debtor's and a commodity producer's best friend. Emerging market economies and stock markets have also breathed a great sigh of relief this year as evidence continues to support the view that the global economy is going to avoid a depression and is likely already on the mend.

It would seem to me that further gains in these markets are still quite likely from a macro perspective, especially as evidence of a U.S. recovery continues to come in. The major risk they face is either a) a double-dip U.S. recession or b) a significant tightening of monetary policy around the globe. I don't think either of those is likely for the foreseeable future.

Full disclosure: I am long SLAFX and EMD as of the time of this writing.

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