The financial markets are surprisingly resilient when it comes to external shocks. The collapse in the futures market in 1987, the Sept. 11 terrorist attacks and even the 1929 market crash were all followed by a full recovery within the next few weeks or months. In some cases, the snap back following a shock is temporary, while other times it can be more lasting. History shows that one shock doesn’t usually have a long-term effect on market prices.
However, multiple shocks, like collapse of Lehman Brothers, Bear Stearns and Washington Mutual in 2008, can have a much longer-term effect when they appear in sequence. Even war and political unrest can have this kind of cascade effect. It’s a rare occurrence, but when it does happen, the memories of those chain-reactions tend to stick in traders’ heads.
Right now, the market is in the middle of what could turn into a new chain reaction. Will the emerging market/Ukraine crises turn into a longer series of disruptions that have that kind of long-term effect? History suggests that this is unlikely. However, it makes sense to be prudent when determining how assets are allocated and to exercise patience before taking a strong position on one side of the market or the other.
What Could Go Wrong?
In this week’s update, we will walk through some of the issues that could turn into a cascade of disruptions and therefore warrant closer observation.
Emerging Markets Can Affect Commodity Prices
The situation between Russia and the Ukraine could not have come at a more inopportune time. Both economies are very important commodity exporters. Oil and energy products from Russia, and grain and corn from the Ukraine could both be at risk. Out of control commodity prices are often a prelude to a deeper draw-down in the financial markets.
Although energy prices haven’t gotten out of control, grain prices are on the rise. Remember the so-called “rice shortage” in January through May of 2008? Emerging markets are very sensitive to food price inflation, and if those economies are squeezed, it will have an impact on developed economies as well.
Economic growth in China, Southeast Asia, Russia and South America are critical for performance in developed economies. Chinese stock markets had already lost nearly half of their value in 2008 before U.S. markets really began their decline as emerging markets reacted to the food crisis.
Traders who want to capitalize on this trend my consider the Teucrium Corn Fund (CORN) that is indexed to corn futures prices. The PowerShares DB Agriculture ETF (DBA) is also an interesting way to take advantage of the rally because it is more broadly diversified.
Corn Futures: Chart Courtesy of MetaStock Professional
The chart of corn futures above provides some important information. Corn traders remain unconvinced that the crisis in the Ukraine is “resolved.” While most other financial markets celebrated easing tensions on Tuesday, corn traders bid the price back up above Monday’s highs. Ukraine is one of the world’s largest corn producers, and the harvest isn’t in yet.
Second, while corn prices are climbing, they are still not in crisis range. The bottom line is that maintaining a certain level of caution is still important, but it’s not time to panic yet.
Emerging Market Currency Stability is Still a Question
In February, emerging market currencies reached a breaking point. Their value had fallen so far that economic stability was seriously at risk. The Fed has received much of the blame here, and it means there isn’t much margin for error available.
In the chart below, you can see a few of the emerging market currencies that triggered the shock and how the easing in February has worn off or even reversed in some cases.
Note: These currencies are compared to the dollar in this chart. Weakness in the emerging market currency will drive the chart up as they get weaker and the dollar gets stronger. If market confidence does start to erode, the dollar is likely to continue getting stronger. Option traders may be interested in call options on the PowerShares DB U.S. Dollar Bullish Index in that situation.
Amongst the emerging markets, China has initiated a program that will intentionally weaken the yuan, which could further erode support for the others. Once again, this doesn’t represent a crisis yet, but it is getting closer. and we have already seen how a surprise move lower can affect developed markets as well.
Will the Chinese Bond Market Start Seeing Defaults?
China is finally reaching its own “Bear Stearns moment,” and will likely see defaults in the short term. The $1.4 trillion Chinese bond market could see its first default soon, as solar manufacturer Chaori Solar warned this week that they will not be able to make their anticipated interest payments. Solar companies aren’t the same thing (economically speaking) as companies like Bear Stearns, but this will be an important first and could be a harbinger of problems to come.
So far, the damage from this news is limited. Chinese stocks are off much more than U.S. stocks as of this writing, but that isn’t very unusual. However, this default is occurring following a significant slow-down in Chinese economic growth. While still considered an “emerging market,” China is also the world’s second largest economy (third if you combine the entire EU), so we might worry that the solar default is a canary in the coal mine. This is definitely be an issue that we will monitor closely.
There are a few ETFs and individual stocks traders may be interested in to capitalize on problems in China. For example puts on the iShares FTSE China 25 ETF (FXI) could rise in value dramatically if the credit market struggles. Bearish traders could also target other Chinese solar stocks in anticipation of the situation cascading out of control or just as a hedge against uncertainty.
For example, Hanwha SolarOne Company (HSOL) has seen a significant decline in its credit situation over the last year.
The Bottom Line for Next Week
Ultimately, the good news seems to be outweighing the bad this week. However, the convergence of external shocks could get worse, as it reminds us of the European debt crisis a couple of years ago that made the stock market shake erratically on a day-to-day basis. While we remain relatively bullish, we expect that volatility will be high in the short term, which means traders need to be patient as they hold their trades and wait for a stronger trend to emerge.