These Foreign Markets Are Flashing A Warning Sign

David Sterman's picture

Tuesday, July 8, 2014 - 1:15pm

by David Sterman

While many investors were headed to the beach or the mountains for the Independence Day weekend, they might have missed a doozy of a jobs report.

Nearly 300,000 jobs were created in June, the national unemployment rate fell to just 6.1%, and the report showed such well-rounded strength that economists are increasingly convinced that the good times will last all year.

By my math, a quickly firming labor market should lead to higher interest rates. I was surprised when interest rates failed to budge after Federal Reserve Chairman Janet Yellen's comments during the release of the minutes from the June meeting of the Fed's Open Market Committee. Yet last week's employment report may be the catalyst to get rates moving higher.

A rise in rates cuts both ways for U.S. stocks. They signal stronger economic activity, but also start to squeeze out comparable income-producing equity investments.

For investors involved with some other major markets, rising rates are simply bad news. A mountain of fresh debt is the culprit, as these economies fell into a classic mistake.

In a recent report, the Bank of International Settlements (BIS) explains: "Financial booms in which surging asset prices and rapid credit growth reinforce each other tend to be driven by prolonged accommodative monetary and financial conditions. ... If a shock hits the economy, overextended households or firms often find themselves unable to service their debt. Sectoral misallocations (such as construction) built up during the boom further aggravate this vicious cycle."

In this instance, the BIS isn't talking about families or businesses, but entire economies. According to a recent Bloomberg report, emerging-market economies have borrowed more than $2 trillion since 2008. They took advantage of super-low interest rates -- and presumably thought that they could simply roll over that debt at still-low rates.

A Key Debt Indicator Is Flashing Red
They should already be on a path to take down some of that debt, before the global economy has its next downturn. But few are doing so. And that sets the stage for a painful reckoning when global lenders stop lending.

"External capital thus often plays an outsize role in unsustainable credit booms, amplifying movements in credit aggregates, and may also induce overshooting in exchange rates," notes the BIS. That means that foreign funds can exit a country quite rapidly, leading to a currency crisis and a run on local banks.

The BIS has been studying debt levels at various countries, and has grown especially alarmed about China. Right now, China has a debt service ratio (DSR) of 9.4%, which means that its borrowing costs equal 9.4% of its export earnings. If global interest rates rose 250 basis points (or 2.5 percentage points), that ratio would rise to 12.2%, the highest of any major economy. Turkey and Brazil are also poised for a quick rise in their DSRs if rates rise that much as well.

Why should you care? "Experience indicates that debt service ratios tend to remain low for long periods, only to shoot up rapidly one or two years before a crisis, typically in response to interest rate increases," according to the BIS.

Turkey's financial picture is proving to be especially challenging. When times were good, Turkish companies and the Turkish government borrowed liberally to build bridges, tunnels, skyscrapers, ports, hotels, shopping complexes, shipping canals, and so on -- but much of that was built with foreign funds that will need to be repaid. Meanwhile, Turkish consumers are aggressive spenders so the country runs a $300 billion current account deficit.

Also of concern: Key trading partners such as Iraq and Egypt are stumbling badly, which is blunting Turkey's trade prospects. This is not an economy built to withstand a rise in interest rates. "The foreign funds that are financing Turkey's expansion are overwhelmingly short-term investments and could be swiftly pulled out of the country," predicts Foreign Affairs magazine.

Turkey has some dubious company. India is also running chronic trade deficits, thanks in part to a huge bill for oil and coal imports.

Europe's Trouble Spots
Despite the sunny appearance provided by rising stock markets, a handful of leading European economies are running both massive trade deficits and large budget deficits.

France, Spain and Italy are all among the top 10 countries in the world in terms of the size of their trade deficits, and these countries haven't made a meaningful dent in their swollen debt loads either. France is a unique case: It's a massive economy that simply appears stuck in the mud, with political deadlock preventing any sort of solution.

Spain and Italy have a fairly straightforward tool at their disposal, which applies to all of the PIIGS (Portugal, Italy, Ireland, Greece and Spain): They need to drop the euro and return to their legacy countries. As long as they're tied to a strong euro, these economies have almost no shot of ever running a trade surplus.

(If you're keeping score, I suggest an end to the euro for the PIIGS around once a year. I still think that this most obvious choice will be pursued when all other remedies have failed).

Risks to Consider: As an upside risk, the U.S. economy is getting healthier, and could soon suck in imports from around the globe at a faster pace.

Action to Take --> Emerging markets hold tremendous appeal for a broad variety of reasons. But it's crucial that you study the macroeconomic factors in place before investing in any country or company outside U.S. borders. The tenuous state of the global economy suggests that some countries (and the companies they host) could see a deeper crisis in the quarters ahead, especially as their borrowing costs increase in the face of rising global interest rates.

Just because a company isn't based in the U.S. doesn't automatically mean it is a "risky" growth stock. In fact, if you're ignoring overseas markets, then you could be missing out on some of the market's biggest income opportunities. All told, we've found 93 companies paying 12%-plus yields -- and nearly a thousand more paying above 6%. That's why we've created a special report that tells you everything you need to know about international high-yielders -- including names and ticker symbols of some of our favorites. Click here to learn more.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.