Thanks to a globally interconnected market system, when Wall Street gets a cold, emerging markets tend to get pneumonia. Any trends in European and North American markets tend to find their way to Bangkok, Hong Kong, Shanghai, Singapore, Jakarta, and Manila. This is the reality emerging market traders need to remember when weighing the impact global oil‘s decline will have on local market performance. Failure to recognize this linkage might lead to some nasty surprises down the road.
Managing risks at liquidity-driven markets
Emerging markets investment is one of the biggest bright spots on the global investment scene. If you invested $10,000 in say, the Philippine stock exchange in 2010, you would have more than doubled your money. The key driver to this massive growth, of course, is a combination of both local economic improvements, governance changes, and, in larger part, easy money policies of the US Federal Reserve that has flooded global markets with investment cash. This over reliance on hot cash inflows leads to a very strong vulnerability. Just as a wave of easy cash can come in and lift the local bourse’s valuations, a wave in the reverse direction can crash valuations. Simple enough, right? Well, the problem is when there is a heavy amount of borrowing by local corporations to take advantage of equities valuations that are largely out of their control.
Heavy borrowing buoyed by the false confidence created by artificially inflated local stock prices is a sure recipe for disaster. If emerging markets were to crash, the oil-induced slump in global markets may provide the trigger, but the implosion will primarily be fueled and exacerbated by huge volumes of local dollar-denominated borrowing. This is an explosive situation because when markets crash, there is usually a flight to quality and the dollar soars. Since these debts are in dollars, local corporate borrowers are doubly screwed by declining stock prices and soaring dollar debt values. Ouch.