Friday, August 21, 2009

Emerging Markets “Bubble” Tested as Chinese Stocks Crack

Emerging Markets “Bubble” Tested
as Chinese Stocks Crack

Dear A-Letter Reader,

At least from my home here in Montreal, the emerging markets

“bubble” appears to be pricked.

Though it’s still too early to tell if this big rally off the October

lows is finally over for emerging markets, investors are glued to

the price action in Shanghai this summer for clues if this is a

correction or the “beginning of the end” for the asset class.
Leader of the Pack or the Biggest Bubble?

Over the last ten years no other global sector has outpaced the

MSCI Emerging Markets Index. In fact, major market stocks

have been a losing bet since 1996.

Indeed, advanced economy markets as defined by the MSCI

World Index and the MSCI EAFE Index (excluding USA) have

declined an average annualized 1.67% and 0.43%, respectively,

since 1999.

The MSCI Emerging Markets Index, however, is up 7.66% per

annum over the last ten years. The BRICS or Brazil, Russia,

India and China have rallied 12.82% per year since 1999.

Emerging Market Bulls Hold their Breath as Xinhua dips into

Bear Mode

Stocks in Shanghai have now declined 20% from their highs this

summer – defined as a bear market.

I don’t read too much into the “20% bear market or bull market

rule,” but it’s symbolic of the long awaited decline since Chinese

stocks hit a low last October. Shanghai equities are up 52% in

2009 and have surged a cumulative 128% since last fall.
Is Chinese Growth Solid?

The Chinese economy continues to grow this year mainly

because of massive government spending and reckless bank

credit growth.

The “easy money” has been flooding into domestic stocks and

real estate. Meanwhile, the Chinese central bank recently

warned about excessive credit.

I seriously doubt the Chinese growth miracle this year because I

can’t imagine where exports are going when more than 50% of

their sales head to the U.S. and Europe – both in savings mode.

Also, contrary to all the hoopla about renewed Chinese

commodities consumption, oil imports fell 2.9% the first six

months of 2009. This contradicts the recovery story already

incorrectly baked into stock prices everywhere since March.
China Leading the World’s Stock Markets (Or Not?)

Over the last three years we’ve seen a gradual shift in market

sentiment…investors are now riding the stock market cycle

based on the primary trends in Chinese equities at the expense

of New York. That kind of thing was unheard of five or ten years


There’s no arguing that China is a major force in global trade

and her voracious appetite for raw materials primes her massive

manufacturing engine.

Yet I find it pretty scary that we’ve grown increasingly reliant on

trends in China, which is still a Communist country masked by

distorted economic data. After all, the Chinese fudge their books

just like everyone else.

I can’t say with any certainty if this is the big correction we’ve

all been expecting. Major averages have not violated support

levels yet. Stocks worldwide also declined about 9% off their

highs from mid-June until mid-July before violently reversing.

The same might happen now. Watch China for clues for market



Eric Roseman, Investment Director of The Sovereign Society

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Editor's Corner:
Arabs Now Fund the War on Terror
The Grim Reality of the Treasury Markets…

Ashish Advani
Editor of Exotic FX Alert

The June Net TIC (Treasury International Capital System) Data

came out this week…and I’ve got to be honest; I trembled in

fear when I peeled the data onion. Let me tell you why...

First, the total holdings of US Treasuries and Long Term Notes

by China fell by $25.1 billion. Our largest buyer of debt has not

only reduced the quantity of debt owned, but also reduced the

maturities from longer term holdings to shorter term (2, 3, and

5Yr) holdings.

But the total flow of Treasuries hasn’t slowed that much. So if

China isn’t buying…then who is?

Further peeling the onion reveals that the largest purchaser of

US Treasuries and Debt was (drum roll please.........) the United

Kingdom (UK).

Wait, WHAT???

If anyone’s having a worse time…if anyone’s prospects are more

grim and debt overhang more ominous than the US, it’s the UK.

I mean, they’re still mired deeply in recession, negative growth,

huge job losses, Housing bubble continuing to burst - And what

do they do? They increase their purchase of US Treasuries? That

just doesn’t add up…

So here’s the secret behind the conundrum – the UK (Bank of

England) isn’t actually buying all those Treasuries.

You see, when the US government parses the data on our side

of the pond, we lump all US Treasury purchases from any UK

source (Private citizens, local banks, foreigners with accounts in

the UK, etc.) into one convenient bucket.

Traditionally (And I know this from personal experience) the

Arabs and the Russians bank extensively and frequently with

institutions in London. Don't ask me why! They’ve done it for at

least the last half-century. London is their favorite banking


And with Oil prices hovering around the $70 mark, there is

surplus cash being generated in the Arab and Russian world

again. And they need to park their cash surplus somewhere.

Hence the Arabs and Russians are investing in US Treasuries via

London. And to the untrained eye, the data appears to indicate

that the UK is buying US Treasuries.

Now the problem I have with this is two fold:

The first is that neither Russia nor the Arabs like the US. Neither

the Cold War nor the War on Terror (which many Arabs view as

the War on Muslims) will be easily forgotten. And if the

argument of dependence on foreign oil holds true, we are

becoming more reliant on the Arabs/Russians.

This Arab/Russian source of funding adds another layer of

complexity to the Federal Government’s ever widening deficit


Can you imagine what smoky back room deals will have to be

worked out…which aspects of the war on terrorists not pursued

– just to keep the money flowing and the deficits funded? For

example, hard decisions such as the use of drones to bomb

terrorist locations in Pakistan without Pakistan's permission…

these kinds of decisions might have to be reviewed.

Of course this is all hypothetical, but just in the last few months,

we’ve seen the kind of clout that China’s been able to exercise

thanks to their donations to the US government.

Secondly, and most importantly, the Oil prices have to stay at

the $70 mark or higher for this source of funding to continue. If

Oil prices fall, then this source of Treasury funding could very

well dry up. If Oil prices rise, the money flows and the deficit

gets funded.

But herein lies the conundrum I see –

If the Oil prices drop, we lose funding of the deficits. If Oil

prices rise or stay high, they’ll impede any growth efforts. And

in the midst of all this, if the Dollar continues to fall, we’ll see Oil

prices rise even further. And the dollar is destined to fall due to

the unending deficit spending that we have under the current


In its effort to “creatively” solve the banking crisis and its

economic fallout, the US government has painted itself into an

even smaller corner…with its success based on even more

contingencies, dilemmas, conundrums and even more satisfied

creditors than ever before.

In retrospect, it might not be a bad time to consider diversifying

into foreign currencies…

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