The Independent Market Observer

2/20/14 – Reader Question: Emerging Markets and U.S. Equities

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Feb 20, 2014 8:44:06 AM

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Today’s topic is a particularly good and timely question from a reader:

“Why would economic problems in other countries, especially smaller, emerging markets, cause a drop in the U.S. equities market?”

I say timely because I was getting questions from reporters this morning about the probable effects of the below-expectations Chinese manufacturing number that was just released. Clearly, the idea is out there that economic problems in China and other emerging markets have a direct impact on the U.S. markets. And yet, if you look at today’s stock prices, the effect is not so direct; prices are actually up, despite the weak Chinese number. What could cause this perception?

Let’s start with the emerging market turmoil earlier this year, which occurred at the same time as, and was associated with, an almost 6-percent downturn in U.S. stock prices. The link between the problems in emerging markets and the U.S. market decline seems clear, doesn’t it?

I would argue that, rather than one causing the other, both were caused by a deeper factor—the Federal Reserve’s decision to start tapering its stimulative bond-buying program. The decision to taper will ultimately result in more expensive money—which is to say, higher interest rates. Emerging markets have been one of the key beneficiaries of low rates, so the prospect of higher rates sent them into turmoil.

At the same time, U.S. stock prices are based, at least in part, on the level of interest rates. As rates increase, the present value of corporate earnings decreases—and so, in theory, does the stock price. What you saw, when emerging markets struggled and U.S. markets declined, was only indirectly related, with the common underlying factor being U.S. monetary policy. The absence of a direct connection is further supported by the fact that U.S. markets have since recovered, even as emerging markets continue to adjust to the prospect of higher rates.

This is not to say that there can’t be a direct connection. There are multiple examples: the Mexican tequila crisis, the Russian financial crisis, and the Asian financial crisis of the 1990s all shook the world markets, including the U.S. The difference in these cases, though, was that the U.S. financial system was heavily involved in these markets, to the extent that the stability of our system was threatened. That could conceivably happen again—and probably came close to happening in Europe in the 2008 crisis—but doesn’t seem to be the case right now. Again, what really drove the effects on U.S. markets wasn’t the economic troubles of the emerging markets but the fact that our financial system was exposed. It was our risk, not their troubles, that drove the decline.

Another possible direct cause of a drop in U.S. markets is the prospect of lower future growth. U.S. companies sell a lot of stuff to the rest of the world. The U.S. and developed markets are relatively slow growing, so for companies to increase their sales, the fast-growing emerging markets are a factor. A slowdown in growth in the emerging markets can spell a slowdown in growth for American companies—and a slowdown in growth means lower future earnings, and lower current stock prices.

All of these factors come into play, along with many others, as we have seen with China today. Overall, the U.S. benefits from higher growth in all areas and suffers from lower growth. The exposure to emerging markets arises from that, as well as our direct exposure to any risks.

Thanks for the question!

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