Can Emerging Markets Dodge an Emerging Disaster?

In today's Daily Market Commentary webinar, we had several questions about the decline in Brazilian stocks, like Petrobras (PBR), and the Brazilian currency, the real. The real is down nearly 20% against the dollar since January, which is not as bad as a decline during the 2015 bear market, but it's still worrisome. 

Emerging Markets Are Often a Leading Indicator

We care about the performance of emerging market (EM) currencies and stocks because they often act as an early indicator of broader market risks. Widespread declines in EM currencies including the real, Turkish lira, and Chinese yuan preceded the bearish shocks the market experienced in the last half of 2015. The connection between EM currencies, stocks, and the U.S. economy may not be obvious at first, but it's important. 

When the U.S. dollar (USD) rises in value, international investors are often attracted to USD assets including bonds and stocks available on U.S. exchanges. The flow of capital from EM economies into USD assets means those currencies are sold, and the USD is bought. All else being equal, that will lower the value of the EM currency which can trigger a selling feedback loop. Poor fiscal and monetary policies in many EM economies have compounded this problem.

As the value of the EM currency falls, imports become more expensive, interest rates rise, and inflation can accelerate within the EM economy. The worst case scenario results in a currency revaluation. In fact, the "real" is the successor to an older currency when Brazil had to redenominate in 1994. This has the potential to be a big problem for EMs, and it can bleed over into developed economies like the U.S. and European Union.

Some scale is important to understand the reasons why this is a concern for investors. The 2nd, 7th, 9th, 11th, and 18th largest economies in the world are all EMs. They may be "emerging" but put together they are much larger than the U.S. 

So far this year, the central banks in Turkey, Russia, Argentina, and India have stepped in to halt the decline in currency values with some mixed success. The cost of doing so is to raise interest rates (Argentina's benchmark interest rate is 40%), which can lead to stagflation. Brazil has turned to the IMF for help, which contributed to a 5% improvement in the real's value on Friday. 

The real's move on Friday is a good sign, but can the rally last? The fight against inflation and falling asset values in EM is probably not defeated yet, but it may be early enough for the IMF and developed markets to head off a crisis if they act fast. The bottom line is that while EM problems haven't seemed to hurt the broader, global economy yet, it is worth watching in order to avoid another 2015-style disruption.

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