Last year, I identified two fundamental problems confronting EMs: (1) the end of the commodity super-cycle, and (2) rising labor costs and social unrest. The commodity producers bet on a commodity super-cycle that started in late 2001, when China joined the World Trade Organization. They spent lots of borrowed money to expand their mining operations, roads, railroad, and ports. That led to increasing supplies of commodities, which put an end to the super-cycle around 2011, when European growth started to stagnate.
As I previously noted, there is a remarkably close fit between the EM MSCI (in dollars) and the CRB raw industrials spot price index. They both peaked at the start of 2011, fell sharply early that year, and have been fluctuating in flat trends since then.
In recent years, rapid growth in the EMs has increased not only standards of living but also income inequality. The result has been social unrest. The response by employers and governments has been to increase wages. Both problems have squeezed profit margins. The forward margin of the EM MSCI dropped from 8.4% at the start of 2011 to 6.4% at the start of this year.
There’s a third problem for emerging markets. The EM MSCI is also highly correlated with the inverse of the trade-weighted foreign-exchange value of the dollar. The dollar has been on a strengthening trend since early 2011, which coincided with the underperformance of the EM MSCI.
It is likely to remain on that course if the US economy continues to grow fast enough to allow the Fed to taper QE and terminate it by the end of this year, as Debbie and I expect. In addition, the euro is likely to weaken if the ECB responds to recent deflationary risks by injecting more liquidity into the Eurozone banking system. Furthermore, the Bank of Japan will most likely continue to pursue ultra-easy monetary policy aimed at weakening the yen. (Yesterday’s FT had an excellent article explaining why “a strengthening US currency spells calamity once again for emerging market.”)
