The big bull market in U.S. stocks is confronted with an unexpected headwind: a fresh bout of financial turbulence in emerging markets.
Wall Street is a world away from Turkey and Argentina and the other developing economies dotting the globe. But recent news of financial tumult and plunging currencies in some emerging markets, coupled with bad memories of past crises over the past 20 years that began in Mexico, Asia and Russia, has imported a boatload of financial angst back to the United States.
Indeed, the great bull market on Wall Street has suddenly run into a stumbling block that few investment strategists were even talking about at the start of the year: swooning currencies and capital flight out of vulnerable emerging markets like Turkey and Argentina.
The financial turbulence, which is being greatly exacerbated by a slowdown in growth-engine China, has raised fears of a potential crisis that could inflict damage on these developing countries’ economies and perhaps infect other nations as well. That lethal combination could ultimately crimp earnings of U.S. multinationals. It could also prompt investors to dump risky assets, a response that already seems to be underway.
Indeed, the emergence of risks in emerging markets, coupled with fresh 2014 headwinds, such as U.S. stocks no longer trading at below-average valuations and Corporate America reporting less-than-stellar fourth-quarter earnings so far, has put the bull market on hold.
In the past two trading sessions the Dow Jones industrial average has tumbled more than 494 points to 15879, extending its year-to-date loss to 4.2%.
It’s the uncertainty surrounding the health of fragile emerging markets, however, that seems to be weighing most heavily on investors at the moment.
Here are some reasons why what happens in emerging markets matters to Wall Street.
*Hot money can turn cold. Emerging markets are the future growth engine of the global economy and an important source of profits for U.S. companies. These developing economies were both recipients and beneficiaries of massive cash inflows the past few years as investors sought out bigger returns fostered by injections of cheap cash from the Federal Reserve and other central bankers.
But now that the Fed has started to dial back its stimulus, many investors are yanking their cash out of emerging markets and bringing the cash back to more stable markets and economies, such as the U.S., hurting the developing nations in the process, explains Russ Koesterich, chief investment strategist at BlackRock.
“Emerging markets need the hot money but capital is exiting now,” says Koesterich. “What you have is people saying, ‘I don’t want to own emerging markets.'”
The combination of less cheap money and a sharp devaluation in currencies in places like Turkey and Argentina makes it harder for these countries to service their debt, especially their current account deficits. A weaker currency also results in higher inflation, which reduces the purchasing power of the people who live there.
As a result, U.S. companies will sell fewer goods abroad and book smaller profits when sales are translated back into more expensive U.S. dollars, says David Semple, portfolio manager at Van Eck Global.
“U.S. companies, particularly multinationals, will see less earnings coming from emerging markets,” says Semple. Add to that the fact that U.S. stock rose more last year on multiple expansion than they did on actual earnings, and it’s a “solid argument for taking some profits,” Semple says.
*Currency crisis could create economic crisis. The bigger fear is if the current crisis in currency markets morphs into a full-blown economic crisis and leads to financial contagion, says Matthias Kuhlmey, managing director of HighTower’s Global Investment Solutions.
“The currency story is fascinating and can be a slippery slope – be cautious,” says Kuhlmey, adding that the Asian crisis in the summer of 1997 that started with a sharp drop in the value of Thailand’s baht, turned into a broader economic crisis that engulfed Indonesian, South Korea and a handful of other countries. It also rocked financial markets.
The good news this time around is emerging markets have learned from past crises and now have bigger reserves of foreign currencies and lower account deficits, which enables them to better withstand the short-term pain caused by capital flight and a weaker currency.
“The world, overall, is more prepared now in comparison to the Asian crisis (in 1997),” Kuhlmey says.
But if growth does slow, investors will have to recalibrate their upbeat outlooks for 2014, says Alec Young , global equity strategist at S&P Capital IQ.
“You have to mark down prices to reflect more muted global growth,” says Young.
*A crisis in confidence could surface. Financial stability is built on confidence, and sentiment can shift quickly if confidence erodes, says Joe Quinlan, chief market strategist at U.S. Trust.
“A declining currency is the clearest sign of investors bolting for the door; it’s a vote of no confidence that usually sparks sell offs in other assets, both credit and equity,” says Quinlan. “And because investors still view emerging market assets as homogeneous, a swooning currency or asset class in one emerging market usually prompts sell offs in other emerging markets, raising the odds of contagion.”
Despite the angst and uncertainty, however, Quinlan envisions a drop for the Dow in the 5% to 7% range, rather than a full-blown correction of 10% or more.
“An emerging market crisis that results in a marked selloff of U.S. stocks would be a gift to those investors underweight U.S. equities or (who have been out of) the equity markets over the past few years,” he says.