Blog : The Globe Strikes Back!

by Ed Zwirn on January 25th, 2014

The globe returned to haunt Wall Street with a vengeance this week. Information released on Thursday about possible weakness in the Chinese economy, following weeks of pressure on emerging market investments, resulted in an implosion for that sector which spilled over to the broader market.

The result was a mini meltdown which saw a worldwide decline for stocks of all sectors and sizes. European shares suffered their biggest fall in seven months on Friday. The FTSEurofirst 300 index of top European shares closed down 2.4%. The index has now erased all its gains for 2014, and is down 1.1% on the year.

U.S. markets performed just as badly. The Dow Jones Industrial Average lost over 300 points on Friday alone, or nearly 2%, to close at 15,879.11, its lowest close since Dec. 17. The broader NASDAQ Composite fell 2.1% to hit its lowest level since Jan. 13, and penny stocks as a group fared worst of all, with the Russell 2000 losing 2.4% and backing up to its Dec. 19 level.

In retrospect, it is easy to see the leadup to this volatility. According to EPFR Global, which tracks funds movements, the week which ended with Thursday's market fall saw emerging market equity funds extend their longest outflow streak since 2002. Its not that the week's outflow has been any more pronounced than the ones which preceded it, but the cumulative effect apparently did a number on the market.

Interestingly, EPFR singled out China as one of the brighter spots within emerging markets. On the other hand, Turkey, which is seeing its government crippled by corruption scandal, and Ukraine, which is witnessing civil insurrection in its capital city, both contributed significantly to the outflows, as did South Africa and Argentina. Dedicated BRIC (Brazil, Russia, India and China) equity funds last posted weekly inflows in mid-4Q12

While all of these countries face structural and political challenges of their own which have contributed to driving their currencies to multi-year lows, most market analysts are citing the fear of Fed policy tightening as the primary negative driver.

This makes sense if we look at what the Federal Reserve's quantitative easing is designed to do. By buying $85 billion worth of bonds monthly while keeping interest rates low, the Fed has not only boosted the U.S. economy, it has flushed investors out to riskier territory (including penny stocks) in general and to emerging markets in particular. This amount has already tapered off to $75 billion monthly, and is expected to be trimmed to $65 billion monthly with the next Fed announcement on Thursday.

Thursday's scare about a possible contraction in China seems to have been the straw that broke the camel's back. With money for investment in emerging markets being increasingly taken off the table due to both local conditions and worldwide monetary policy, the last thing investors needed to hear bad news about the powerhouse country of the emerging markets category.

At the same time money was being pulled from emerging markets stocks, the securities of more developed parts of the globe were seeing a huge cash influx. Just ahead of their markets tanking, Europe equity, bond and money market funds took in over $22 billion. Year-to-date flows into Japan equity funds began pushing over the $4 billion mark. Even U.S. bond funds took in fresh money for the third straight week, something that last happened in mid-Q2 2013.

But, as Thursday and Friday's trading results show, these massive fund inflows did stocks in developing countries no good, or at least no short-term good. Instead, the rapid disinvestment from emerging markets which occurred at the end of last week, following weeks of continuous pressure on that sector, proved to be too rapid for most tastes.

At least at this point, we have no idea of the extent to which an emerging markets meltdown would pose systemic risk to stocks. Of course, there is the legitimate economic impact to companies as the value of their Philippine joint ventures or the revenues they get from China bottom out. But beyond that it is hard to guess at the investment impact to financial companies. The trades which may need to be unraveled as major financial institutions lose bets on Ukrainian sovereign debt or stock in a Turkish manufacturer can only be guessed at. As the derivatives crisis showed us, the value of these bets can (and usually do) greatly exceed the value of the underlying stock or bond.

Any hint of such a catastrophic impact only serves to illustrate the straitjacket in which Janet Yellen is likely to find herself when she chairs her first FOMC meeting this week. The tapering may play well enough at home, but it exerts a great deal of pressure on emerging markets, some of which are seeing their governments try to stay in power amidst protest and scandal while seeing their currencies tank and their bond yields rise. If the stock markets of these countries can go under without causing "too big to fail" scenarios elsewhere, then Thursday and Friday ought to prove to be no more than a blip on the screen and cause no derailment of Fed policy.