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Contagion?
Toronto: January 27, 2014
By John Stephenson

Markets tumbled this past week, culminating in a 300-point plunge in the Dow on Friday.  Mounting worries about Turkey, Argentina, South Africa and other troubled emerging markets and the impact of Fed tapering caused investors to dump so-called risk assets, sending global stocks and currencies tumbling.  Emerging markets were the hardest hit, but soon the contagion spread to major equity markets in Europe and North America as a fear set in. 

The decision by the Argentinian government to suddenly yank the support out from underneath the peso, which caused the currency to tumbled by twenty percent in a few short days.  This past Thursday the peso had its single biggest one-day drop against the U.S. dollar since its debt default in 2002.  While the beleaguered Argentinian government pledged to keep the currency at its lower rate, the move generated knock-on effects in Brazil, and the risk of a broader contagion across emerging markets has now become real.

With Argentina’s currency plunging, central banks in India, Russia and Turkey as well as a handful of other countries intervened to shore up their currencies with modest success. Turkey tried and failed to support its lira, despite the central bank’s aggressive effort, pumping an estimated $3 billion into the foreign exchange market. A growing corruption scandal and a massive current account deficit are some of the reasons investors took last week’s weakness as an opportunity to dump the Turkish lira.

Last week, Russia’s ruble fell 2.9% while the Turkish lira was off 4.2%, but the real worry is not just the selloff, but also the fact that currency weakness is often a prelude to a larger economic crisis.  For some, this is reminiscent of the 1998-98 Asian currency crisis which started in Thailand, spread across emerging Asia, wiped out a huge U.S. hedge fun and leveled Russia, wreaking global havoc.   

Investors are also fretting about China, after a downbeat manufacturing survey last week showed that the industrial economy stalling.  But its China’s massive levels of debt that really have investors spooked.  No other emerging market has built up so much debt in such a short time.  Already, cracks are appearing in China’s shadow banking system, which has been a major driver of the nation’s credit explosion.  State-owned banks are the biggest culprits in this shadow banking system and they represent one of the main sources of finance for investment projects in China—supplying one-third of the new credit in 2013. Given the country’s dependence on cheap credit, reigning in this shadow banking system before the bubble in real estate and infrastructure bursts may prove problematic for the Chinese government.

Global companies are taking a second look at emerging markets and deciding that they may not be the best place in which to invest after all. Ford Motor Co. is cutting production in Venezuela and General Motors has slashed 1,000 jobs in Brazil while Magna International has put a hold on new spending in South America.

In what appears to be a repeat of last summer, emerging markets are once again being cast in a negative light after the iShares MSCI Emerging Markets ETF (EEM) dropped 3.9% last week, its largest one-week decline since June 2013. Other funds that focused on Brazil, Chile and Turkey fell more than 5% last week, as investors hit the sell button.  

In response to the global uncertainty, Treasuries have rallied 25 basis points so far this year, as investors have poured nearly $4 billion into bonds. With emerging markets looking increasingly risky, a flight to safety has begun with the bonds issued by the U.S., Germany and Japan being the big beneficiaries. 

But despite the turmoil, the troubles in Argentina and Brazil are unlikely to derail the global economy.  Only a massive blow-up in China, a country that accounts for a third of the emerging world’s gross domestic product and fifteen percent of global output has the potential to derail the recovery in the West.  With U.S. GDP data out in the next week the odds favor a greater than three percent growth rate in America for the fourth quarter, which should help buoy investors and stabilize the markets.  While I’m expecting a few more days of selling pressure, I’m looking forward to jumping back into the fray when things settle down.

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