Emerging Markets: Another Asset Bubble Popping

The emerging markets asset bubble is popping.  Financial markets in China, Brazil, Turkey, Russia, and India have been falling, with no end in sight.  Commodities prices have declined.  And the major stock markets--in Japan, Europe and the U.S.--have been dragged down in consequence.  All because the Fed began to reduce its quantitative easing program.

We've been here before.  Fed easy money policies contributed to the tech stock craze of the late 1990s and the real estate and mortgage bubbles of the 2000s.  Those earlier bubbles popped when the Fed began to withdraw accommodation.  You have to wonder whether the Fed will ever learn:  long periods of accommodative policies inevitably create asset bubbles somewhere, and when the accommodation is reduced, the bubble will pop.  Painfully, since there is no other way for an asset bubble to pop. 

When tech stocks, and then real estate and mortgage markets, crashed, recession and unemployment followed.  The results included, among other things, higher and higher levels of unemployment and greater inequality of income and wealth over the past 15 years.  When the Fed repeatedly uses its very blunt monetary weaponry to combat economic slowdowns, the rich get richer and everyone else stagnates or declines. 

What will the Fed do in response to the emerging markets downturn?  Initially, nothing.  It will hope that the positive momentum that has emerged in the U.S. and to a limited degree, in Europe, will be enough to maintain overall global economic equanimity.  But if the decline extends for several more months (particularly in major stock markets), expect the Fed to rethink its stance and get the monetary printing presses revved up again.  As we have discussed before (see http://blogger.uncleleosden.com/2014/01/expect-nothing-from-government-in-2014.html), fiscal policy will be darn near nonexistent this year.  Fed easy money policy is the only way for the federal government to combat economic distress.  And even if more money printing means yet another asset bubble a few years down the line, and more income and wealth inequality, the only choices nevertheless remain easy money or easy money.  The Fed's policies are the only game in town.

One might lament that the Fed never seems to learn that too much accommodation leads to yet another asset bubble that pops, causing distress and dislocation that leads to more accommodation, which only continues the cycle.  But the problem is the Fed has little choice.  Congress and the White House mostly stare at mirrors and ask who is the fairest of all.  The business community waits for the federal government to stimulate the economy, reduce its risks and heighten the potential for profits.  The Fed personifies moral hazard:  the rest of the world has learned that, when push comes to shove, the Fed will act.  So there's no need for anyone else to step out front and center and take the lead. 

How do we break this vicious cycle?  Well . . . uh . . . there was once a time--long, long ago--when the private sector would lead the way out of recessions.  Businesses would start to expand, banks would start to lend, investors would start to take risks.  But how likely is that to happen now? 

Batten Down the Hatches for the Dog Days

This could be a stormy summer. Like the mortgage debt crisis three years ago that blew up and froze the financial markets, there's a nontrivial chance the government debt crisis could do the same this summer. Government debt, normally the investment of last resort, is starting to look hinky. With respect to the federal debt ceiling, some Republicans in Congress seem intent on provoking a default in August. Biting the hands that feed us--i.e., stiffing investors in U.S. Treasury securities--hardly seems like a good idea for a debtor nation. But "smart politician" is virtually an oxymoron these days.

More than America, the Euro bloc lurches inexorably toward default. For the moment, Greece is the only nation that is likely to formally default. However, all Euro bloc members have pretty much assumed de facto responsibility for all the sovereign debt and bank debt of all member nations. So a default by Greece is, in effect, a default by the entire Euro bloc. Such a development would not be well-received in the financial markets. But Euro bloc leaders are divided about what to do, and progress toward true resolution is seen about as often as the ivory-billed woodpecker.

Although another financial crisis is a low probability event, the simultaneous dysfunction in Washington and Europe could make things go haywire in the dog days of this summer. After all, nothing has been done since the last credit crunch that would preclude another one this year. What to do?

Love cash. Have a cash lovefest. Build up your emergency fund and put it in a bank (making sure it's 100% covered by FDIC insurance). Avoid non-essential big purchases for the next few months to increase cash on hand.

Be cautious with money market funds. If U.S. Treasury securities actually default, money market funds might have to break the buck. A sudden spike in interest rates could reduce the value of their T-bills and impose losses on the funds. Although the extent of such losses is likely to be comparatively small, given the very short maturities that money market funds are supposed to hold, it's not impossible that a freeze-up in the Treasury securities market could result in money market losses and perhaps momentarily limit access to your account. This is a low probability event, and fund management companies would probably go to great lengths to avoid breaking the buck. But it happened once in 2008. If you are likely to need funds in a money market account in the near future, consider moving the necessary amount into a federally insured bank account in July if the debt ceiling mess remains unresolved.

Invest defensively. Now's not the best time to take a flier, except if you have mad money you can easily afford to lose. Note how the Nasdaq market has, in recent days, been falling proportionately faster than the Dow and the S&P 500. Many risk assets are falling, literally, out of favor. Be careful about diving into emerging markets. China's economy is slowing, and India's and Brazil's governmental yield curves are inverting (seen by some as a sign of impending recession).

Avoid unnecessary financial commitments. If you're thinking of making a major financial commitment, like buying an annuity or a whole life insurance policy, consider stepping back and waiting to see how things play out over the next few months. If, for example, you buy an annuity now, and Treasury yields rise sharply later this year because of a U.S. government default, you may effectively have lost money because you would have bought at today's low interest rates.

Line up credit lines now. Credit could evaporate if things go gonzo. While borrowing is to be avoided if at all possible during a financial crisis, there sometimes are pressing reasons to go into hock. Line up any loans you'll need. Since it's even possible a bank might terminate the unused portion of a line of credit if the sky falls, you may want to draw down on credit lines now if you are absolutely sure you'll need the money and have no other way to get it. Make damn sure you can repay what you draw down. And keep the loan funds in a bank account, not a money market fund.

All this may sound on par with suggestions to stock freeze dried food and bottled water, and to start a garden in your back yard. But we haven't had to rely on subsistence farming in more than a century. Just three years ago, credit was crunched and the financial system almost failed. As far as money goes, take nothing for granted.