Emerging Market Developments And The Impact On U.S. Equity Markets

Recent developments in emerging markets such as Turkey, Ukraine, South Africa and Argentina have caused consternation in the U.S. equity markets, contributing to the ~ 7% decline in the Dow Jones Industrial Average year to date. For example, the Turkish lira has dropped over 20% since December due to concerns over the Fed’s tapering of its quantitative easing program and a political corruption probe in the country. Similarly, the Argentine peso declined by close to 20% against the dollar on January 23rd alone.

The emerging markets panic is the first of several possible unintended consequences to come out of the Federal Reserve’s tapering of its monetary easing programs and low interest rate policies. Investment cash flows to emerging markets increased significantly during the economic recovery as investors hunted for higher yielding investments than what was available in the U.S fixed income markets. This increased flow of funds to emerging markets caused appreciation in emerging market currencies, equities and fixed income alike.

Due to an improvement in underlying U.S. economic fundamentals, the Fed now appears to be set on a course of ending quantitative easing by the end of 2014. Since the Fed’s decision to begin tapering its asset purchases under QE in December, emerging markets investments and currencies have come under some pressure. This is because the yields on U.S. assets are beginning to look more attractive now that interest rates are rising and are expected to continue to rise in coming years. Ironically, the flight of capital out of emerging markets could end up benefitting the U.S. markets in the long run, as that excess flow of funds will inevitably find its way to more developed markets, including the U.S., which remains the most liquid, safest and largest capital market in the world.

Compounding the impact of the Fed’s monetary policy shift, recent economic data out of China has indicated a potential slowdown in economic growth there as well. China, the world’s second largest economy, is obviously a major economic force, particularly with respect to its trade activity with various emerging market nations. Thus, the recent disappointing data exacerbated the flow of funds out of emerging markets in January.

The market reaction to developments in the emerging markets and China is not wholly surprising to us. While the abruptness and the degree of the currencies’ devaluations were unexpected and troubling, we believe that the market’s decline was also an inevitable consequence of the Fed’s policies. In addition, we continue to be of the opinion that the markets were ripe for a breather after a near 30% gain in the S&P 500 last year. Because many investors often wait for a new year to realize investment gains as a way to delay the tax impact of those sales, rather than realize gains at the end of the year, a decline in January was likely. Combined with global indicators of economic weakness and the Fed reducing some of its support of the markets by tapering its quantitative easing, a 5 – 10% correction is now in progress.

Corrections are a normal and healthy part of any bull market. They tend to occur only when there is a good reason to correct! In January, emerging markets and China provided the impetus for a correction. Yet, we believe that investors should not lose sight of the positive economic momentum in the U.S. that bolstered the markets in 2013 and will continue to provide support in 2014. There will be bumps along the road, but we believe that the bull market will recover.

Finally, the long term philosophy that determines the investment choices for our clients’ portfolios is and will continue to be based on those drivers that have stood the test of time, for example: interest rates (low), inflation (low), GDP growth (steadily improving), corporate profits (higher than expected), and accommodative monetary policy. None of the above drivers have significantly changed recently and they are not expected to change significantly in the foreseeable future. In our view, the only thing that seems to have changed is the negative short term psychological impact on the investment public from the traders’ reaction to the recent market moving events in emerging market countries.