Emerging Markets Mess: Blame It On The Fed?

It is yet unclear as to whether or not the current mess in the emerging markets EEM will morph into a full-fledged crisis (remember the fun of 1998?). However, it is safe to say that the focal point of the stock market remains the currencies, economies, and equity markets of places like China FXI, Argentina, Turkey TUR, South Africa EZA, and Brazil EWZ.

The problem for a great many investors though, is that the reason behind the decline remains unclear. Sure, everybody "gets" that it's all about the emerging markets right now. Yet, the question of "why" may be the real issue. And since the primary objective of this oftentimes meandering morning market missive is to identify the drivers of the stock market, we thought it might be time to try and answer the question.

Lagarde Nailed It

International Monetary Fund Managing Director Christine Lagarde is on record as saying that central bank easing in the U.S., Europe EZUand Japan EWJ may be responsible for what she calls the ticking time bombs in emerging markets.

Ms. Lagarde said that the extraordinary policies may cause damaging, though unintended, consequences as low interest rates push investors to take on more risk - in places like the emerging markets.

"When the tide turns, and interest rates pick up again, these hidden dangers will be exposed to the cold light of day," Lagarde warned Wednesday in a speech at the Economic Club of New York.

Thus, it would appear that Ms. Lagarde provided investors of all shapes and sizes with a very timely warning. As of last Wednesday, the S&P stood at 1844 or some 3.5 percent higher than it closed on Monday and the EEM (iShares Emerging Market ETF) was nearly 6 percent higher. All one had to do was listen to a very public figure making a very public pronouncement about the dangers in the emerging markets, right?

But, oops... wait a moment. It wasn't last Wednesday that the IMF chief issued her warning. No, it was Wednesday, April 10, 2013 - or more than nine months ago. My bad.

Should We Really Blame The Fed?

At the time, it sounded like Lagarde was arguing against further QE from the central bankers of the world. However, given that the U.S. economy had encountered a speed bump of sorts each spring for several years running, the call to give up on QE fell on deaf ears.

The IMF chief stated that the free flow of cash coming out of the U.S. Central Bank, the Bank of England, the ECB, and the Bank of Japan, was beginning to find a home in places like China, South Korea and Brazil.

The thinking was that the flood of capital helped boost the growth rates in many emerging markets, perhaps artificially so. Investors loved the high yields from emerging market bonds. Investors loved the growth rates seen in the emerging market economies (remember, this was before #GrowthSlowing in China was a thing). So... the fear was that if and when the QE cash flow spigot was turned off, each and every one of these countries could suffer.

You see, big capital inflows can (and apparently did) create pressures on exchange rates (i.e. the currencies of the emerging market countries). In turn, the free flow of money fueled very rapid credit growth. And we all know what happens when countries take on too much debt.

It's About the Money Flows

Again, while the comment is nearly a year old, Lagarde's words ring true today. She told the Wall Street Journal last April that the greatest worry for the emerging markets "is a sudden reversal of large and volatile capital flows that can bring down the economy with it."

Anybody care to guess what is happening these days in the emerging markets? Yep, you guessed it; "volatile capital flows."

With rates rising in the U.S. and the widely held expectation that such a trend will continue for some time, those massive flows into the emerging markets seen over the past couple of years are now reversing.

Why invest in Turkey or Argentina when you don't have to any more, right?

They Tried To Provide "Guidance"

Before you start blaming Ben Bernanke and the Fed's "taper light" for the trouble in the emerging markets, please keep in mind that the FOMC has been yammering on about tapering for quite some time. If you will recall, it was May of last year that "Gentle Ben" first started hinting about tapering the QE bond buying program. As such, the fact that the Fed is now actually doing what it said it was going to do shouldn't come as a surprise to anyone, anywhere.

Things Don't Matter Until They Do

But did investors connect the macroeconomic dots here? Uh, no. Remember, on Wall Street, things don't matter until they do - and then they matter a lot. And apparently artificially inflated currencies in Argentina, Turkey, and South Africa didn't matter. Well, until last week, that is.

Will these issues continue to matter? Is a 3.5 percent pullback in the S&P 500 good enough to convince the dip buyers to continue to do their thing? Or is this the beginning of the meaningful correction that many analysts have been warning of? Again, time will tell. So, stick around because the slow and steady march higher that marked the stock market of 2013 appears to be over. Nope, it looks like investors may have to work a bit harder in 2014 for returns - especially if they own any emerging market stocks or bonds (we don't).

Click Here to Receive the full "Daily State of the Markets" report each morning before the opening bell. Dave's full report includes a list of the current market drivers, trend analysis, key technical levels, six momentum indicators, two early warning indicators, the weekly State of the Market Model, pre-open analysis, and a thought for the day.

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