Kass: Who Else Is Swimming Naked?
Surprise No. 13: Africa becomes a new hotbed of turmoil and South Africa precipitates an emerging debt crisis.

Politics and economics form a potentially toxic cocktail.

Africa triggers an emerging-market crisis and becomes a flashpoint of geopolitical risk and political turmoil as the region's untapped oil wealth is recognized.

Not long ago, South Africa was meant to be the "S" in the BRICS, alongside fast-growing Brazil, Russia, India and China. The rand, however, is in steep decline, and the nation has growing budget and trade deficits and slowing growth, so it can hardly claim membership in that club right now.

At some point in 2014, the ratings agencies will downgrade South Africa, foreign money will flee, and the country will be in a full-blown financial crisis that will trigger a wider selloff in the emerging markets and could highlight problems at emerging-market central banks (which are already suffering from slowing economic growth, an acceleration in inflation, etc.).

Potentially changing regimes due to national elections in Brazil, India, Indonesia and Turkey cause those countries to join South Africa in the emerging markets' bumpy ride, which is further impacted by U.S. dollar strength caused by the Fed's tapering.

If the crisis intensifies and expands beyond South Africa, a contagion into the developed banks could raise additional concerns and pull down money center bank shares.

-- Doug Kass, " 15 Surprises for 2014"

Risk and contagion happen fast.

Usually the crowd outsmarts the remnants, but we should always beware of turning points!

It is helpful, particularly in periods of complacency (and in aging bull markets) such as we faced late last year, to consider out-of-consensus surprises and events that could unexpectedly influence the markets.

That is probably why Byron Wien started his surprise list years ago, and it is why I started mine and mimicked Byron's a decade ago.

Arguably, this whole global market downturn in January has been the outgrowth of complacency and that most were already in the pool -- in other words, progress was discounted in valuations (which rose an outsized 24% in 2013).

Consider the strong consensus views as we entered 2014:

  • Japan, which is now down 8% year-to-date, is the best region in which to invest;
  • stocks will outperform bonds;
  • the rate of global economic growth will accelerate;
  • interest rates will rise.

And there's more, but let's keep this list contained.

By contrast, the risk of contagion was an important theme in my surprise list for 2014 (see surprise No. 13 above); it was a risk that was ignored by many. Indeed, few risks were considered following the outsized market gains last year, a sentiment that is embodied in Adam Parker's quote below.
"The only thing people are worried about is that no one is worried about anything.... That isn't a real worry."

-- Adam Parker, chief U.S. strategist at Morgan Stanley
The baton handoff from Helicopter Ben to Whirlybird Janet has initialized an effective tapering, and monetary policy is in the process of being normalized.

In light of that tapering has already come a swift price discovery in the capital markets, a price discovery that had previously been sabotaged by the massive bouts of liquidity delivered by the world's central bankers.

The key issue over the next few months is whether the problems and contagion in the emerging markets impacts the developed markets.

I reached out to a good friend who is among the best in the macro world -- I don't have permission to name him, but you all know him -- who expressed the case for a containment of contagion, which is presented below.

  • The currently troubled emerging market regions represent a minor portion of global GDP and S&P earnings.
  • While the economies in the emerging markets are slowing, the economies of Japan, Europe and the U.S. are expanding.
  • Central banks of troubled emerging market countries understand the risks and are easing.
  • Emerging stock markets have massively underperformed already, suggesting a lot has already been discounted.
  • External debt/GDP ratios are not problematic, and foreign-exchange reserves are ample relative to imports.

Nonetheless, to this observer, Turkey is likely the tip of the iceberg of that discovery, for, as Warren Buffett once wrote, "Only when the tide goes out do you discover who's been swimming naked."

Whether or not this is the end of the five-year bull market is uncertain.

What is certain is that the investing and economic backdrops have changed -- and not for the better.

This column originally appeared on Real Money Pro at 8:07 a.m. EST on Jan. 30.
At the time of publication, Kass and/or his funds had no positions in any stocks mentioned, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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