The Bombay Stock Exchange is in Mumbai, India, one of the nations whose stocks are seen as fragile. Photo: Mansi Thapliyal, Reuters
Something had to put the brakes on last year’s almost vertical ascent of the U.S. stock market – and that something has been emerging markets.
A stew of concerns has sent the MSCI emerging markets index down 7.3 percent this year. The MSCI developed markets index is down 4.4 percent, and the Standard & Poor’s 500 index is lower by 4 percent.
Surprisingly, the MSCI frontier markets index – which tracks stock markets too tiny to be considered emerging – is up 1.2 percent. The index includes Middle Eastern, Eastern European and African markets such as Bahrain, Bangladesh, Botswana and Bulgaria.
What’s going on here? If you haven’t been following closely, this might help explain things.
Q: When did the rout in emerging markets start?
A: In May, when the Federal Reserve hinted it would start tapering its bond-buying program known as quantitative easing, or QE. Emerging markets had been big beneficiaries of that policy, which reduced interest rates on safe-haven Treasury bonds and sent investors scurrying into riskier assets.
The unwinding of QE and the prospect of higher Treasury yields has reversed that money flow somewhat, sparking a sell-off in emerging markets dubbed the “taper tantrum.”
The drop accelerated after the Argentine peso plunged 15 percent on Jan. 22. Although Argentina itself is not a threat to the global economy – foreign investors haven’t loaned money to the country since it defaulted on its debt in late 2001 – it was a wake-up call.
“Speculators smelled blood in the water and said, ‘Who’s next?’ That was a trigger to set off problems for other countries that were similarly situated,” says Brian Jacobsen, chief portfolio strategist with Wells Fargo Funds Management.
Q: What countries are those?
A: Some call them the “fragile five,” generally Indonesia, South Africa, Turkey, Brazil and India.
They are this year’s equivalent of the PIIGS – eurozone countries (Portugal, Ireland, Italy, Greece and Spain) whose economies were on thin ice after the financial crisis. Investors feared a sovereign debt default by one would spread to others. That didn’t happen, but measures taken to prevent it did cause economic pain.
The fragile five are different in that they don’t share a common currency. Each has its own set of problems. “Every unhappy emerging market is unhappy in its own way,” quips Barry Eichengreen, a UC Berkeley professor of economics and political science.
What the five have in common is a high current account deficit, the result of imports exceeding exports.
Q: Why is that a problem?
A: Countries import more than they export by borrowing from the outside world. When U.S. interest rates were low, “everyone was enthusiastic about lending them money because their interest rates were higher. Now that everyone thinks U.S. interest rates will go up because of tapering, there is at least the possibility that it will be harder for them to finance their deficits,” Eichengreen says.
If borrowing gets more expensive, these countries will have to tighten spending and could end up in recession.
Q: Which of these is the biggest risk?
A: Turkey, probably. It grew like wildfire during the boom, building a tunnel under the Bosphorus Strait and high-speed rail thanks to cheap foreign money.
But when capital started flowing out of the country, its currency, the lira, began to plunge. To stem the drop, the central bank announced a sharp increase in overnight lending rates on Jan. 28.
“Raising interest rates is a way to buy time, to convince investors to stick it out a little longer,” Eichengreen says. “But they are only going to stick around if other steps are taken to fix whatever is wrong.”
Turkey’s prime minister, however, “undermined the effectiveness of that policy. He said he didn’t support it,” Jacobsen says.
Q: Why is this affecting the United States?
A: “Emerging markets make up 40 percent of the world economy, and their forecasted growth is twice that of the U.S.,” says Nathan Rowader, director of investments with Forward Management.
Bill Rocco, a senior fund analyst with Morningstar, says some emerging market funds buy stock in multinationals, such as Procter & Gamble or Nestle, “because so much of their revenues come from the developing world.”
Q: Why are frontier markets outperforming emerging markets?
A: They have a lot of the same characteristics, such as high growth rates and reasonable valuations, Rowader says. But they didn’t participate in the Fed-fueled boom that swept many emerging markets.
“You have a lot more patient money that has been going in there. You don’t have a lot of fast money going in and out,” Jacobsen says.
Their economies and stock markets are dominated by local banks, utilities, hospitals and retail operations. “Some are fairly large exporters, but they are fairly young economies,” Rowader says. They can grow by modernizing their economies and improving banking controls.
Q: How will this play out?
A: “Keep your eye on China,” Eichengreen says.
Unlike the fragile five, China has a large external surplus. The problem there is slowing growth and possible problems lurking in its financial system.
“Historically China has grown about 10 percent a year, for the next 10 years, it is expected to grow 7 percent,” Rowader says.
That is still robust by U.S. standards, but any slowdown could expose problems in its financial system and could lead to a slowdown in emerging markets, which have been exporting commodities to China.
Rowader says investors should reduce their exposure to emerging markets. “Sentiment has not quite gotten negative enough,” he says. “I see a larger drawdown on the horizon” that will present a better buying opportunity.
But Jacobsen says the worst may be over for some emerging markets. “I think we will see continued pressure and problems in Argentina, Venezuela and Brazil,” he says. Turkey “is as wild card.”
Other countries, such as India, are already turning, he says. He predicts that both emerging markets and U.S. stocks will end the year higher than they are now, but they could go down more before they go up.
“Now is the time to be looking, not running from emerging markets,” Jacobsen says.
Read more at http://www.sfgate.com/business/networth/article/How-emerging-markets-slowed-U-S-stocks-climb-5215255.php
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