Sell Off or Panic?

01/27/2014 11:00 am EST


Jim Jubak

Founder and Editor,

After the global market's overall downtrend last week, MoneyShow's Jim Jubak questions whether the response will be a sell off or a panic, and warns of several ramifications for you to watch out for.

What's ahead, sell off or panic?

After Friday's action, I think we can take “buy on the dip” off the list of alternatives.

Everything was down Friday—with the surprising exception of the Shanghai Composite index (IND:SHCOMP), which closed up 0.6% overnight.

At the close, the Standard & Poor's 500 index (SPX) was down 2.09% and the Dow Jones Industrial Average (INDU) was off 1.94%. Mexico was 1.33% lower and Brazilian stocks were down 1.1% in Sao Paulo. In Europe, the German DAX (DAX) had tumbled 2.48% by the close of that market; in Milan, Italian stocks were down 2.30%; and in Spain, the IBEX 35 index (IBEX) was lower by 3.64%.

In Asia, Hong Kong's Hang Seng (HSI) closed down 1.35% and Japan's Nikkei 225 (NKY) was off by 1.94%.

Among other emerging markets, Turkey's BIST 30 index (IND:XU030) was lower by 1.74% and South Africa had dropped by 1.36%.

What's going on?

I think we're seeing a renewal of the emerging market currency sell off that we saw repeatedly in 2013, on rumors—and then on the actual decision—that the US Federal Reserve would begin to taper off its $85 billion a month in purchases of US Treasuries and mortgage-backed securities. That taper, it was widely concluded, would strengthen the dollar and increase the attractiveness of dollar-denominated assets as US interest rates rose. That hit hard at emerging market currencies, especially those of countries such as Brazil, Turkey, and India that rely on overseas cash inflows to balance persistent current account deficits.

Add in recent data that argues that China's economic growth is slowing from 7.8% in the third quarter and 7.7% in the fourth quarter, to something below 7% by the end of 2014, according to pessimistic forecasts. Slower growth in China means slower growth for economies—such as Brazil and Australia—that depend on exports to China. Slower growth in those economies will turn into slower growth for the global economy as a whole, it is feared.

And finally, in the last few days, we've ratcheted up both those currency and China growth fears on news that 1) Argentina would allow the peso to plunge without central bank intervention, 2) Turkey's central bank had intervened in the markets but had not been able to stem the fall of the Turkish lira, 3) Brazil's government budget was deteriorating so quickly that the country might face a credit rating downgrade this year, and 4) at least some of the trust investments in China's shadow banking system looked unlikely to recoup the money they had lent to companies and local governments.

I take all these fears seriously and the fundamentals, in some cases, look rather dire.


The question for the global markets now is whether everything will sell off in a panicky reaction, or whether traders and investors will discriminate between those markets that should be sold on fundamentals, and those that are actually poised for a decent performance.

For example, Brazil continues to slide deeper into real trouble. Inflation finished 2013 at 5.91% within the Banco Central do Brasil's target band of 4.5%, plus or minus two percentage points. But inflation is that low only because the central bank has raised interest rates seven times since April—with the last being a 50 basis point increase two weeks ago to 10.5%. That has sent GDP growth plunging to 2.2% in 2013 and in forecasts for 2014.

With growth slowing, government revenues have tumbled, and with elections looming this year, there's almost no chance that politicians will vote to cut spending. Brazil's primary budget surplus, the money left before interest payments, has dropped to 1% of GDP, and that's less than the 2% to 2.4% primary surplus needed to stabilize public debt as a percentage of GDP, HSBC Holdings calculates. That creates the danger that one of the credit rating companies will cut Brazil's credit rating in 2014—and that the central bank will have to raise interest rates again to fight inflation and to stabilize the currency.

With those fundamentals, it seems appropriate that Brazilian stocks have hit five-month lows in January and that the real continues to be one of the world's worst performing currencies. On the fundamentals, I'd certainly advise lightening up further on Brazil.

Contrast that to Mexico. Instead of an economy coupled to China through commodity exports as Brazil's is, the Mexican economy is coupled to that of the United States, a developed economy forecast for better growth in 2014. Add in a recent credit rating upgrade from Standard & Poor's that gives Mexico an investment grade rating from all three major credit rating companies. Plus, likely energy sector changes that would open up the country's oil industry to foreign investment and the promise to gradually increase oil and natural gas supplies and lower the country's energy prices. On the fundamentals, Mexico deserves buying and not selling.

If what we're looking at is just a sell off, then I'd expect those fundamentals to count, and for Mexican stocks to hold up better than those of a country such as Brazil. If this is a panic, however, I don't think those fundamentals will count for much and Mexican stocks that trade in New York might even show a bigger loss, since they are relatively easy to sell (and to rebuy down the road).

If this is just a sell off, I'd like to hold onto—and maybe sooner rather than too much later buy on weakness—stocks in emerging markets such as Mexico, Peru, and Colombia. If this is a panic, those markets will sell off too—heavily—as money runs, without discrimination, from anything that smacks of risk.


I think what happens in China over the next couple of weeks will go a long way toward deciding between sell off and panic. Certainly, the long market holiday that comes with the New Year, which begins on January 31, isn't encouraging anyone to hold onto positions. But if the official Purchasing Managers Index number, due for release on February 1, comes in above 50, thus showing growth, in contrast to the contraction in the recent HSBC/Markit Economics PMI survey, then I think growth worries will recede a little and markets will calm, to some degree.

For that calming to be significant, however, I think markets need to see evidence that recent troubles with trust investment products aren't about to turn into mass defaults in the shadow banking system.

The problem here is that the numbers support the fear of default. The loans behind $660 billion in China investment trusts come due in 2014, and many of these loans were extended to companies that may or may not be able to repay them. The specific trust loan that set off fears of an investment trust default this week is a $500 million loan to a now defunct coal mining company that was due to be repaid on January 31. That loan was repackaged as an investment trust and sold to investors with a promise of a 10% yield. The selling documents didn't exactly highlight the risk in this product.

China's investment trust market totals $1.2 trillion. Loans from these trusts finance everything from company expansion, to property developments, to government infrastructure projects. If worries about the safety of these trusts cause this source of financing to dry up or to rise in price, it would certainly slow the Chinese economy. If, on the other hand, the national government forces local governments and banks to honor the implicit guarantees against loss that many investors in these trusts believed they were getting, then any trust defaults would ripple out through China's financial system.

It's not going to be easy to put fears to rest that China's economy is headed to growth of 7% or less, or that China's shadow banking sector—the source of about 30% of total credit recently—is about to freeze up or implode. It may take until the middle of 2014 for policy at the People's Bank to show that fears of these outcomes are excessive.

To me that suggests that, at best, we're looking for continued weakness in emerging market assets in general, for the next few months, until we get positive news from China and prices that are low enough to justify the name of bargains. At worst, however, we'll get news that turns any sell off into a true emerging market panic. Panics in emerging markets do eventually result in amazing bargains and superlative returns for those that had money available to buy at the bottom.

At the moment, poised as we are between sell off and panic, I don't think you need to rush to buy. Keep some powder dry until we know more about how bad the current drop in emerging markets is going to get.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund, see the fund's portfolio here.

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