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How bad will things get for emerging markets? And will the pain spread?

The mess in emerging markets is spreading beyond Turkey and Argentina. John Stepek looks into how things have got so bad, and what's likely to happen next.

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India's currency has slid heavily

Emerging markets are looking messy. This is no longer just about the likes of Turkey and Argentina.

The broader emerging market index has fallen by more than 20% from its January high, notes the FT. That puts it in a bear market (that's not a particularly official definition by the way, but it's the one most people use for equities).

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So far, the hardest hit (beyond the two aforementioned walking wounded) have been Indonesia, Brazil and South Africa, both in currency and stockmarket terms. Emerging-market corporate debt has struggled too.

The question now is: how much worse will it get? And will it spread?

The two main reasons why emerging markets are struggling

Overall, it's not particularly surprising that emerging markets are struggling. There are lots of market-specific issues: Brazil's election chaos; Turkey's economic incompetence and authoritarianism; Argentina's unfortunate credit record. But increasingly, investors are refusing to discriminate. And there are two main reasons for that.

Firstly, the US dollar is strong. That, in turn, is the result of the Federal Reserve continuing to tighten monetary policy. Everybody needs US dollars. So when the price of the US dollar goes up, money gets tighter around the world. Particularly if you have borrowed in dollars, and have to make your repayments from an income that consists of pesos or lira or rupiah.

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Tighter monetary policy also decreases risk appetite. Why venture far afield for your yield if your bank or US Treasuries will pay you an above-or-close-to-inflation income once again? That's a big change and it'll have an impact on all risk assets, not just emerging markets. But they're feeling it first because they're out on the far end of the risk spectrum.

Secondly, the globalised, borderless (at least, as far as capital went) world that we all took for granted is under threat. The US has decided that the world order no longer works in its favour. So it wants to rewrite the rules so that it stops getting ripped off, as it perceives it. And it's gradually doing that.

That is likely to disrupt or even dismantle (in some cases) trade flows. A lot of business models and national economic models were based on those trade flows. Some of them may no longer be viable.

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And if you're looking to the November US elections to set things back to the way they were, then don't. Whatever your view of Donald Trump, it's worth understanding that he is the instrument, not the instigator of this. That's why people voted for him. So while a genuine challenger to Trump might be more competent or more stable or more likeable (or potentially even more dangerous), they will have to promise similar levels of change.

(Bear in mind that people voted for change too, in 2008, in the form of Barack Obama. They just didn't get as much change as they wanted.)

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So there are your two "big picture" reasons for the current havoc. What does this imply about the next phase?

What could happen next?

Given the problems I've outlined above, I suppose the question is: will the dollar weaken, and will Trump compromise on trade?

Rather than keep you in suspense, I'll tell you what I think right now. In the short term, "quite possibly" for both. In the longer run, "maybe" on the first, and "probably not" on the second.

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On the dollar I discussed this earlier this week, but there are reasons to think that Trump may not want to see too much more dollar strength. And the Federal Reserve can't have failed to notice the problems in emerging markets, although whether it feels it should take account of them is another matter.

I've long assumed that the Fed would rather be behind the curve than ahead of it, and I still think that's the case. Jerome Powell is, however, doing a good job of convincing markets otherwise. I'm curious to see how long that display of sanguinity can last.

On trade this is going to be an ongoing issue. It's quite an easy one to manipulate politically. So ahead of the US mid-term elections, Trump can manufacture a victory. And then, after they're done, he can get aggressive again. And the US relationship with China will continue to be tricky the uneasy symbiosis of the pre-2008 days is over.

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What does this imply?

If the malaise in emerging markets is going to spread ("contagion", as the jargon has it) then one of the first to show the signs will be the German market, reckons Julian Brigden of MI2 Partners. "German companies who have grown fat on exporting to EM [emerging markets] are watching their underlying markets weaken."

And if this rolls over, notes Brigden, "it's going to be tough for US stocks to ignore the weakness". So watch out for trouble in Germany as an early warning sign.

At the same time, however, I think there's a good chance that markets will get back into "buy the dip" mode before that happens, either because the Fed says something, or because some piece of US economic data gives hope of a rate pause.

In the longer run, however, it's probably important to be pickier about which emerging markets you invest in. One that I'm keeping an eye on in terms of buying opportunities right now is India. The rupee has slid heavily, but I'm still keen on the economy's long-term prospects. I'll take a closer look at the options for buying in, in a future Money Morning.

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