Should you be keeping an eye on emerging markets gas in oil briggs and stratton engine

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In last Wednesday’s Money Morning I wrote about the strengthening greenback and said to keep an eye on it. Conveniently having it both ways, I said the strengthening US dollar could foreshadow the start of a bear market…or it could be nothing — a minor rally after months of falls.

‘ Emerging markets currencies faced further selling on Monday on the heels of the worst week in more than a year, with a resurgent dollar and a slew of local issues sparking jitters among investors. In early European action on Monday, the JPMorgan emerging markets currency index slipped 0.29 per cent.

‘ US Treasury yields have pushed markedly higher over the past month, with a robust economy expected to prompt the Federal Reserve to increase interest rates a total of three to four times this year. In fact, the 10-year climbed from 2.73 per cent at the start of April to above 3 per cent by April 25. Higher yields take some of the polish off of the carry trade, in which investors borrow in lower-yielding countries to buy debt in higher-yielding ones. The trade has been a boon for demand of EM currencies, according to analysts.’

This ‘carry trade’ is an important consideration. Basically, it works like this: Traders borrow US dollars and pay interest at a relatively low cost, thanks to the US Federal Reserve. They then sell these dollars and buy emerging market bonds paying a higher rate of interest. As long as the underlying currency doesn’t fall too much, then the carry trade is a profitable one.

When this trend is in full force, the dollar falls and emerging currencies strengthen, as does the value of underlying emerging market assets like bonds and equities. This usually happens during a global economic expansion when risk appetite is strong. When the Tide Turns…

But at certain times, the tide turns…and it turns quickly. Which is what you’ve seen over the past few weeks with the dollar rallying so strongly. The flip side of that coin is falling emerging market currency values, rising bond yields and falling stock prices.

That doesn’t have to mean anything sinister, but given the rich valuations seen in US stock markets especially, you’d have to think that even a slowing of global economic growth in the latter half of 2018 wouldn’t go down too well with stock markets. Or maybe that’s what the current correction is pricing in already?

At this point it’s worth keeping a close eye on emerging market stocks. As you can see in the chart below, the iShares MSCI Emerging Markets ETF [AMEX:EEM] is trading close to fairly crucial support. A break below there would suggest that the world is indeed moving into a lower growth phase.

Funnily enough, you’re not seeing a major sell-off in commodity prices or producers on the back of a strong dollar. This tells you that for now at least, global growth is holding up. More than that though, it also suggests the supply side response to higher commodity prices over the past few years or so is muted. That is, there isn’t a whole bunch of new supply about to come online. Global Economy Slowing Down?

Take oil prices, for example. Brent crude is at a three-and-a-half year high. That tells you global demand is robust, at least on the surface. The thing about commodity prices is that they aren’t a great leading indicator. They don’t give you a good read on where the economy is going.

While it might be looking shaky, the bull market is still intact. And while I might think that is in the process of changing, what I think doesn’t matter in the slightest. What matters is what the market thinks. Because if you run one way and the market runs another, you’re not going to make any money.