There’s not many times you can say we’ve seen one of the all time worst one day routes in a stock market index, but today was one of those days.
The S&P Merval index plunged 48% in US dollar terms after the surprise trouncing of the current business friendly president Mauricio Macri, in his party’s primary for president. He was expected to lose the primary but not by such a wide margin to Alberto Fernandez, the Peronist candidate who has the former left wing president, Cristina Fernandez de Kirchner, as his running mate. The only other one day route that was this bad was in 1989 in Sri Lanka, when the country was in the middle of a civil war.
Source: Bloomberg
The ETF’s that follow Argentina suffered as well but not as bad as the Merval index due to how these ETFs are structured.
Source: Yahoo Finance
The list above is dominated by relatively small emerging markets, which begs the question, why are emerging markets so volatile?
The Economy
In a paper published last year by researchers at the Federal Reserve, the authors showed that GDP is much more closely linked to the price of a few commodities in many emerging markets as compared to developed markets.
Source: St. Louis Fed
To explain in more detail, the authors found that there were important structural differences in emerging economies compared to developed ones. Take for example imports versus exports. They documented that commodities made up 71% of exports and 33% of imports on average in emerging economies while in developed economies those figures were much more balanced at 29% and 31% respectively.
When the price of a commodity increases, for an emerging economy this increases the return for capital and has knock on effects to incomes and employment. Since they are producing much more than they consume, the external force of the boom is felt locally through these factors while not impacting what they consume by as much. On the flip side, when prices fall, they still have the same import needs but lower incomes with more unemployed which exacerbates the cycle.
The authors estimate that the difference in what they produce versus what they consume can explain about half the volatility in GDP of emerging countries, which is a pretty significant proportion given all the noise that goes on in the functioning of a national economy.
Financial Capital
The other reason for such volatility has to do with the mobility of financial capital and the sheer size of it in developed markets compared to emerging markets.
Below you will se an old but relatively straightforward example. If there is a boom in emerging markets and 5% of global capital shifts away from developed to emerging markets, this represents 5.6% of developed market capital moving away. However it represents a 45% jump in emerging market capital. When the shoe drops and that capital leaves again during a bust to developed markets, it represents a huge slump.
Source: marketoracle.co.uk
Although the above is based on market capitalizations of 2008, the story has not changed dramatically since then. Just take a look at the world market cap of all stocks by nationality in January of 2018 below.
Source: S&P
Developed markets are still at least 80% of the entire world market cap in stocks which makes the capital inflows and outflows for emerging market economies still incredibly volatile. Couple that with the already volatile GDP for factors mentioned above and you have a recipe for big swings in terms of the fortunes of both the financial sector and economies of emerging market countries.
Conclusion
Despite this, much of the future growth of the world will still be found in those emerging markets. China, which is still considered emerging, even though some say by now it has arrived, will play an ever more important role in global equity returns. Just take a look at the predicted world market cap breakdown in 2030.
Source: S&P
Whether we like it or not China and other fast growing countries like India may play an ever more important role in the growth of savings of millions of people. That isn’t to say it won’t be bumpy along the way, so be prepared for that rocky road to growth ahead.
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