Assets Flee Developing Economies

What the Little Trees of Argentina can Teach American Investors

Assets Flee Developing Economies
February 5, 2014

In a posh neighborhood of Buenos Aires, not far from the Argentine Central Bank, a government foreign exchange shop sits brooding and idle. Yet on a side street nearby, the trade in black market currency is brisk. For there -- and throughout Argentina -- one can find the arbolitos (“little trees”), a rough tangle of men and women, seemingly “rooted” to their spots, trading pesos for American dollars at a lively clip.

At government currency shops – where the “official” exchange rate is controlled at 8 pesos per dollar – Argentineans are barred from converting more than 20% of monthly income into dollars. With no government-imposed limits on exchange rate or volume, the arbolitos are cleaning up, The demand by Argentineans for black market dollars (called dolars blue, or blue dollars) appears insatiable.

The reason for this flight to greenbacks is simple – inflation has returned to Argentina, as it has to many developing economies around the world, including Turkey, South Africa and India. While developing economies handily outperformed developed ones during the economic stagnation of 2007 to 2012 – igniting a flight of capital to developing countries – it is the developed economies that are now showing signs of life.

Case in point is the US, where the economy grew 3.2% in the fourth quarter, following a brisk 4.1% advance in Q3. US exports are also strong, and job growth is steady if not spectacular. There are bright spots in Europe as well, with the UK growing more in the fourth quarter than at any time since Q1, 2008. Spain also had a better performance in Q4 than during any quarter over the past six years.

As developed economies grow, they can unwind the stimulus policies enacted during the economic downturn. These policies – such as the Federal Reserve’s $75 billion monthly bond buying program -- were designed to keep interest rates low to encourage business growth. These low interest rates, in turn, spurred massive migration of capital from developed economies to developing ones, as investors pursued the higher returns available there. This flood of money helped lift the value of both currencies and equities throughout the developing world for more than half a decade.

However, now that developed economies are growing, stimulus is being dialed back and developing economies are paying the price. How? Simply consider the power of the almighty Fed. In both their December and January meetings, $10 billion were lopped off of that humongous Bond Buying program, slashing February purchases to $55 billion. Additional tapering is said to follow. This super-sized pullback on stimulus – combined with improving US growth – is pushing interest rates higher, which makes American debt more attractive to global investors again.

This lure of higher returns in the US – and in other developed economies – is causing a reverse flight of capital back to these powerhouses, as investors pursue the twin virtues of growth and safety. Taking it on their collective chins are the developing economies, which are simultaneously enduring massive export reductions to China, as manufacturing in that country slows markedly.

These combined headwinds are driving brutal declines in currency values throughout the developing world, along with higher inflation and depressed equity values. The recent carnage includes:

  • Russia – On January 31, the ruble approached a five-year low.

  • India – Inflation is now running at a 10% annualized rate, causing their Reserve Bank to raise the repurchase rate.

  • South Africa – The collapsing rand fell to its lowest rate against the dollar since 2008.

  • Turkey – The lira sank to its all time low against the dollar on January 28.

  • Chile – The peso hit a four-year low on January 31, while inflation is running at its highest in two years.

  • Argentina – 2013 inflation was 28%. It’s at an annual run rate of 48% in January. Moreover, the peso is at a twelve-year low to the dollar.

As you can see, things are especially daunting in Argentina, where the peso is in free fall and people are desperate to hedge personal finances against yet another inflationary tide.

This brings us back to the arbolitos, the “little trees” who turn pesos into “blue dollars” on the black market. What can they teach MoneyTips readers about investing in this climate of global turmoil?

Above all, they remind us to consider the pernicious impact of inflation. While the hyperinflation we’re seeing now in Argentina will not spread to the US and other developed economies anytime soon — due largely to the power of central banks to control interest rates — the fact remains that rates are steadily rising after several years of historic lows.

Accordingly, our readers might wish to consider the following tips for their money:

  1. Be Cautious of Bonds - As interest rates rise, bond values fall, so be cautious about fixed income investing.

  2. Consider Precious Metals - Gold, silver and platinum are the classic hedges against inflation. You may wish to increase your holdings of precious metals or invest in solid mining stocks, which all tend to rise in value when the cost of living goes up.

  3. If Considering Real Estate, Buy it Now – Rising interest rates means higher mortgage rates— and interest payments — over the life of your loan. For example, if you finance $1,000,000 for a home purchase today for 30 years at 4.5%, your monthly principal and interest payment will be $5,067. Over the life of this loan, you’ll pay $824,000 in interest. But if mortgage rates climb over the next few years to 8% (not at all impossible), your monthly payment climbs nearly 50% to $7,338, and total interest paid over 30 years metastasizes to $1,641,552. Therefore, if you’re considering that dream home, you might want to grab it now.

As always, you should consult with a trusted financial advisor before making significant investments. But if the arbolitos are right, we should all stay mindful of inflation.

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