Last year, I identified two fundamental problems confronting emerging markets: the end of the commodity supercycle, and rising labor costs and social unrest. The commodity producers bet on a commodity supercycle 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 supercycle around 2011, when European growth started to stagnate.
As I previously noted, there is a remarkably close fit between the MSCI Emerging Markets index (in U.S. dollars) and the Commodity Research Bureau 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.
In recent years, rapid growth in the emerging markets 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 MSCI EM index dropped to 6.4% at the start of this year from 8.4% at the start of 2011.
There’s a third problem for emerging markets. The MSCI EM index 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 MSCI EM index.
It is likely to remain on that course if the U.S. economy continues to grow fast enough to allow the Fed to taper QE and terminate it by the end of this year, as we 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.
Source: Ed Yardeni — Ed Yardeni is the president and chief investment strategist of Yardeni Research Inc., a provider of independent investment strategy and economics research for institutional investors.