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Emerging Markets’ Ebbing Tide

We’ve previously expressed caution in June and August 2013 about the emerging markets. We hereby do so again.

The rising tide of emerging markets since the start of the 21st century was fueled in particular by two major trends.

First, there was the rapid economic growth of China, the world’s most populous nation. Then came the aggressively easy monetary policy of the US Federal Reserve, to support our economy, the world’s largest.

China’s blistering growth, bringing it to second place among the world’s economies, created demand for a wide range of commodities, goods and services. Other emerging markets, especially those with significant natural resources, benefited most.

Then Fed policy, which slashed savings and bond yields while creating a tidal wave of liquidity, encouraged global investors to pour large sums into the fast-growth emerging markets’ equities, high-yielding bonds and direct business investments.

Both of the two major trends began to lose momentum some time ago. As is usually the case when sharp market declines occur, there had already been numerous warning signs.

China’s annual gross domestic product (GDP) growth was 11.4 percent in 2007. After dropping during the financial crisis, the growth rate rebounded to 10.4 percent in 2010. But it has since fallen each year, to 7.7 percent in 2013.

Emerging markets have been notably weak since last May, when the Fed first raised the prospect of tapering its $85 billion of monthly bond purchases.

Indeed, emerging-markets investments have lagged those of the slower-growth developed nations for some time: stocks for three years and bonds for a year. And various emerging-markets currencies also had been weakening in recent months.

But the retreat started to accelerate last week and it continued this week. This has happened several times before, most recently in 1998.

Last week brought news of a slowing economy in China, with an index of Chinese manufacturing, the most important part of the country’s economy, unexpectedly contracting for the first time in six months.

Cracks had already been appearing in China’s shadow banking system, which has been a major driver of the nation’s credit explosion that many believe has created a property and infrastructure bubble. A slowdown in China would hurt other emerging markets, many of them important suppliers.

Emerging markets were already on edge. The Fed’s gradual tapering of its quantitative easing program is reducing the flow of investor money into emerging markets. Meanwhile, India, Turkey, Brazil, Argentina, South Africa and others are suffering from a variety of specific problems, such as slowing growth, rising deficits, tumbling currencies, higher inflation and political turmoil.

Hasta la Vista, Baby

This week, at one of its eight scheduled decision-making meetings per year, the Fed said it would cut back on its monthly bond purchases by $10 billion. This is the second $10 billion reduction from $85 billion.

In its accompanying statement, the Fed’s assessment of the US economy was virtually unchanged from the one after its last meeting, in December. The recent turmoil in emerging markets wasn’t mentioned, suggesting that the Fed sees little or no threat to the US economy from the emerging-markets woes. In effect, the Fed said “Hasta la vista, baby” to those nations, as one wag put it.

Ironically, the emerging markets’ troubles make the Fed’s ongoing task a little easier. Low US Treasury yields, depressed by the Fed’s policies, pushed yield seekers into higher-risk vehicles, such as emerging markets bonds.

Now many investors who were chasing yields in emerging markets have been exiting those positions because of soaring yields and falling currencies, which both slash the value of their investments. The selling only exacerbates the currency declines.

Meanwhile, a return to US Treasurys by investors seeking a safe haven has pushed down long-term bond yields here. The yield on benchmark 10-year Treasury issues has tumbled from 3 percent to 2.65 percent in January alone.

Turkey, South Africa and India all raised various interest rates this week in an attempt to support their currencies. But they and others may need additional rate hikes. That and the exit of foreign capital could hurt various emerging-markets economies.

Many of the affected nations likely have enough capital reserves to ride out the turmoil. But others, notably Turkey and Argentina, are more vulnerable. So it’s no surprise that, in a time-honored tradition, leaders of both nations are blaming foreign conspirators for the troubles. For instance, Turkey’s already besieged prime minister Erdogan has promised to “choke” market speculators.

Inevitably, the latest emerging-markets sell-off spilled over to the developed markets. It’s a small world, after all. So January was a tough month for stocks worldwide. But the damage was considerably less here in the US than elsewhere.

Using the leading exchange-traded funds (ETFs), here are the 2014 returns through Jan. 30 for US investors in various global markets, via the leading ETFs:

S&P 500: -2.8 percent
Developed Europe: -3.2 percent
Japan: -4.1 percent
Diversified emerging markets: -8.8 percent
Thailand: -6.1 percent
Taiwan: -6.3 percent
Singapore: -6.5 percent
Malaysia: -7.2 percent
Mexico: -7.2 percent
India: -7.3 percent
South Korea: -8.9 percent
China: -9.7 percent
Brazil: -11.3 percent
South Africa: -11.7 percent
Russia: -11.9 percent
Turkey: -12.7 percent

Just as the emerging markets have underperformed for a long time, a sustained recovery likely will take a while. The developed markets, particularly the US, should continue to do better.

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