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Why the trouble in emerging markets isn’t the end of the world

Paddy Hirsch Jan 27, 2014
Whiteboard

Why the trouble in emerging markets isn’t the end of the world

Paddy Hirsch Jan 27, 2014

Yes, the U.S. stock market fell out of bed on Friday (and still looks bruised today) as the selloff in in emerging markets hit lemming-like proportions, but just because the Dow got dinged is no reason for us to panic.

So what happened in emerging markets last week?

Basically, investors decided to pull out a lot of the money that they had parked in those economies. They had bought a bunch of stock; last week, they decided to sell it.

Why was all that money in emerging markets in the first place?

There’s a rule of thumb in finance: Money always flows to the place where it will make the biggest return for the smallest risk. Emerging markets are usually seen as pretty risky, but because of the low growth, the low interest rate environment we’ve been in since the financial crisis, investors were having a hard time finding investments that would make money. So they got creative, and money flowed to places that investors usually fear to tread, such as junk bonds and emerging markets.

OK, so why sell now?

Well, money has been flowing out of emerging markets for quite a while now, but the outflows peaked last week for a couple of reasons. First: Reports that China’s economy may be weakening. Concerns about the country’s debt levels had the bulls pulling in their horns, because China is such a big trade partner with many emerging nations. Then, there’s speculation about U.S. Federal Reserve reducing its bond-buying program: The program has been such a stimulant to emerging markets that investors worry that if it is reduced too far too fast, it could stunt those economies’ growth. Investors worry that the end of the program means a stronger dollar (which hurts countries reliant on external financing), and higher interest rates (which will make it more attractive to invest in places other than emerging markets).  

Where did all the money go?

It’s hard to say. It certainly didn’t flow into the U.S. stock market, as we saw. Instead, investors looked as though they sought refuge, probably opting to hold cash and buying U.S. Treasuries, which did see a lift last week.

How can you be so complacent about the fact that these economies are melting down?

OK, I don’t mean to be complacent: This is bad news for these economies, and market volatility is never a good thing, for anyone. But the affected economies are not exactly “melting down” at this point (well, maybe Argentina). They are seeing some pullback in investment, which is not good for their growth, and they will experience some short term pain, but it doesn’t necessarily follow that the US will suffer terribly as well. For one thing, their problems do not appear to pose a systemic risk, in the way that the Asian Financial Crisis did in 1997. For another, the pullback is patchy: Brazil dipped because it’s such a big trade partner with China; Argentina dropped because of its currency disaster; South Africa slumped on fears of a platinum miners’ strike; the Ukraine has credit market issues and Turkey has currency problems. But other emerging market economies, such as Mexico, appear unscathed, and may even be attracting investment.

So why did our stock market drop on Monday?

For one thing, investors got nervous. And when they’re nervous about one thing, they get nervous about everything. So there’s a spillover effect there. But also bear in mind that emerging market nations are big customers of the big multinationals that trade on the US stock exchanges. Some companies, like GE, IBM, Dow Chemical and Ford depend on overseas markets for more than 50 percent of their revenues. If things are going bad in these emerging econmies, it means the people there will likely spend less on the goods sold by these multinationals. And, therefore, those companies will make less money.

Shouldn’t we be worried about contagion in these emerging markets?

We should always be worried about contagion, and there’s quite a debate raging about whether contagion is likely in this case. Certainly some countries that were awash in cash thanks to the Fed’s bond buying program will now be left high and dry, and looking for bailout help from international institutions. The problem is that investors often lump economies together in the emerging market basket regardless of their fundamentals, and may be prompted to sell off the whole lot in a panic. So far, that doesn’t seem to be happening, but if it does, that’s when contagion will really kick in. And then, yes, we will have a problem.

 

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