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The emerging market meltdown that occurred between May 12 and June 13, 2006, had an impact on currencies, the carry trade and incredible growth in derivatives over the last decade, as described in Part 1.

In summary, here are the issues we will be examining in part 2.

• An index that has been uncannily accurate in providing advance warning of emerging market trouble and what it is saying now. 
• What the yield curve inversion for the third time in the last six months means. How accurate has it been in the past in warning of a pending slow down? 
• Based on the importance that real estate and related construction activities play in economies around the globe, what impact will a real estate correction have?
• Real wage growth, a principal driver in consumer spending, has been trending down since 1965. What does it mean for the economy going forward?
• What are the most important cycles saying about what to expect in the coming months and years? 
• Finally, we will tie these factors together to provide an overall snapshot from 30,000 feet and suggest what it means for markets in the future.

Real Emerging Market Risks

Figure 6 – Chart of the JP Morgan Emerging Market Bond Index from initiation in December 1990 showing areas of relative lows (red ovals) and Dow bear markets (grey boxes).

In the late 1980s, Brady Bonds came into being, designed to spread the risk of loaning to emerging markets from governments and large international banks to international investors willing to play the game. To track the risk of these instruments, JP Morgan introduced a number of indexes including the Emerging Market Brady Only Index (EM_Brady), the Emerging Market Bond Index Plus (EMBI+) and Emerging Market Bond Index Growth Performance (EMBI_Performance). These indexes plotted the difference between a basket of emerging market bond yields and comparable U.S. Treasury yields – the lower the value (spread), the more complacent global investors were becoming about emerging market risk.

The EM Brady Only was initiated in December 1990 and the EMBI indexes go back to 1993. Putting the two together with data from JPM produces the chart shown in Figure 6, a composite of the EM Brady Only (1990-93) and the EMBIG Performance (1993- present).

It is interesting to note that each time that spreads have shrunk to a relative low, some sort of emerging market fiscal crisis and/or bear market followed (see Figure 6).
Note the lows: 

1. December 1993. Eleven months later the Tequila Peso crisis occurred and there was also a bear market in U.S. stocks. 
2. September 1997. The Thai baht crisis started in July 1997 as the index was at new all-time lows and developed into the Asian flu. 
3. December 1999. That relative low was followed by a bear market in U.S. stocks. The Nasdaq bear started in March 2000. 

On May 1, 2006, the EMBI+ and EMBIG - Performance hit historic lows of 172 basis points. The May 12-June 13 “canary” correction followed. Unless the relationship has changed, we should expect more trouble in the coming months. Every time global investors become complacent about emerging market risks, look out.

Figure 7 – Monthly chart of the difference between 10-year and 2-year yields. Red arrows show inversions, grey boxes show bear markets. Also shown are the percentage gains in bull markets and drops in bear markets for the Dow Industrial Average. The orange line is a 50-month moving average.