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Does This Crisis Belong to Emerging Markets or US Stocks?


While the focus is on economies overseas, it is the United States markets that are most vulnerable.

There cannot be a crisis next week. My schedule is already full.
--Henry A. Kissinger

The media continues to hammer on emerging markets, making comparisons to 1997 and 1998 when in reality the current situation is nowhere like what occurred over a decade ago. China may indeed be in contraction, emerging market currencies may indeed be vulnerable, but nothing is more vulnerable in my opinion than US markets on a comparative basis. For too long investors have assumed that the US stock market was a bastion of safety. The Fed has our back, and won't let things falter. No belief is more engrained in the investor psyche than that of the Ben Bernanke (and soon to be Janet Yellen) Put.

Yet, puts expire. The Federal Reserve is clearly on track to continue tapering and simply does not want to be in the business of QE anymore. Perhaps this is because there is a growing realization that this has been the only iteration of Fed stimulus that has failed to juice inflation expectations. After billions of dollars being pushed into financial markets, deflation concerns remain elevated. So, too, is irrational exuberance, which was given an explicit nod in the last meeting's minutes over small-cap valuations. US markets are considerably richer than those of emerging economies. To argue that US stocks can't go down more than emerging markets when emerging markets have priced in tremendous bad news is completely and utterly illogical.

The real surprise would be if US stocks, over the next few months, began sinking at a faster pace than emerging market stocks. This is a very real possibility. Take a look below at the price ratio of the SPDR Barclays High Yield Bond Fund ETF (NYSEARCA:JNK) relative to the Pimco 7-15 Year US Treasury Index ETF (NYSEARCA:TENZ). As a reminder, a rising price ratio means the numerator/JNK is outperforming (up more/down less) the denominator/TENZ. A falling ratio means the opposite.

This is one way of tracking credit spreads, which gives a sense of risk-taking and risk aversion within the bond market. Healthy bull environments tend to be characterized by junk debt outperforming "risk-free" Treasuries. Corrections and deflation pulses tend to be characterized by the opposite, as the above ratio falls. Note that after an incredible run up, the ratio has broken down meaningfully. Keep in mind that this is US-centric. A further break here would indicate growing risks in US markets, not emerging economies.

One can consider credit strength as the last pillar for risk-taking, and that pillar may be toppling over. If indeed this is the beginning of a period of credit stress, then the correction we may now be in is far from over.

Twitter: @pensionpartners
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No positions in stocks mentioned.

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