2018 is shaping up to be an exceptional year for U.S. equities. The S&P 500 Index, comprised of the 500 largest U.S. publicly traded companies, has smashed through all-time highs and set a record for the longest bull run in history. This exceptional performance has been due, in large part, to a strong earnings season tied together with encouraging economic data points. Some of these key data points include:
A record-low unemployment rate.
A rising advance-decline line (a technical indicator measuring the number of advancing stocks less the number of declining stocks).
27% year-over-year earnings increase and 11.2% sales growth in the S&P 500 since 2010 and 2011, respectively.
Though these figures are cause for celebration, Wall Street seems to be ignoring the elephant in the room: emerging markets. While the S&P 500 has gained 7.5% year-to-date, MSCI’s Emerging Markets ETF (EEM) has declined 11.8% since the start of January. Much of this significant decline can be attributed to three causes:
The fear of an impending trade war sparked by President Trump's tariff and trade balancing measures.
The U.S. Federal Reserve's decision to follow through with rate hikes going into 2019. Emerging market countries tend to run account deficits and rely on foreign capital to fund these deficits. When the Fed raises rates, ‘carry trade’ becomes increasingly expensive and less attractive to investors.
Currency woes across the globe. As of now, the mayhem in emerging market seems to be contained, heavily impacting the countries depending on overseas money. Some of these affected countries include South Africa, with the Rand down 19.43%; Argentina, with its Peso down 52.70%; Turkey, with the Lira down 43.23%; Brazil, with the Real down 20.37%; and India, with the Rupee down 11.03%.
As these currencies tumble further, governments frantically try to halt, or at the very least decelerate the fall. For example, the Turkish Government increased regulations on foreigners shorting the Lira, the Brazilian Central Bank offered 15,000 currency swap contracts in an effort to reduce volatility, and the Argentine Central Bank raised rates from 45% to 60%, in addition to requesting a speeding up of the $50 billion bailout from the International Monetary Fund. Despite all these proactive measures, currencies continue to falter against the U.S. dollar.
Even though the US market is performing well, the Federal Reserve's effects on emerging market currencies has highlighted international dependence on the USD. Worries are now shifting to EM contagion as higher bond yields and expensive debt (caused by the Fed’s rate hikes) could possibly shift currency flow out of emerging markets, hindering local economies and international trade. Some of these effects have already been highlighted in the most recent Institute for Supply Management survey, indicating that America’s factory activity is at the highest level since 2014.
By Sean O’Dea and Paul Menestrier - Portfolio Management Analysts, Baruch Investment Management Group