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Stand clear of falling knives

Last week's emerging-markets rout could be just the beginning.

  • By Ben Levisohn,
  • Barron's
  • – 01/25/2014
  • Emerging Markets
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Pick a horror flick, any horror flick, and it's likely to be an apt metaphor for emerging markets right now. But our favorite might actually be a comedy, Spaceballs, in which John Hurt, reprising his role in Alien, shouts, "Oh no, not again," as a tiny extraterrestrial pops out of his belly.

Yes, again—but this is no laughing matter. Emerging markets are once more front and center after the iShares MSCI Emerging Markets ETF (EEM) dropped 3.9% last week, its largest one-week decline since last June. Funds devoted to Chile, Turkey, and Brazil, meanwhile, fell more than 5% last week as investors headed for the exit. Sure, that looks a lot like the turmoil that hit emerging markets last year, when global interest rates started to rise after the Federal Reserve broached the topic of curtailing its bond purchases. This time, however, something worse could be brewing: A repeat of the emerging-market crises of the 1990s.

Last week began with few signs of trouble. In fact, it appeared as if emerging markets might actually be strengthening—the EEM was up 1.1% on the week through Wednesday. On Thursday, however, an indicator of Chinese manufacturing strength showed activity contracting, Argentina stopped trying to prop up its peso, and Turkey tried but failed to support its lira—and the rout was on. Noticeably missing was the fear of rising rates that hit emerging markets last year. The response to the emerging-markets selloff has been to buy bonds issued by the U.S., Germany, and Japan. As a result, the U.S. 10-year yield has dropped to 2.74% from 3.05% at the beginning of the year.

That's a sign that what's happening in emerging markets has more to do with local conditions than what's going on overseas. Brazil, for one, reported Friday that its current account deficit widened to $8.7 billion, bringing its 2013 deficit to a record $81.4 billion. Turkey's own current account deficit is dwarfed only by a corruption scandal that has already made investors wary of investing. And the fear is that the problems of a few emerging markets will tar the entire asset class, despite differences in their economies and financial situations. "This is a domestically created problem," says Michael Shaoul, CEO of Marketfield Asset Management. "And we haven't seen anything like this since 1998."

The currency market will be key. Last week, Argentina's peso plunged 15%, Turkey's lira dropped 4.2%, and Russia's ruble fell 2.9%. The problem: Currency weakness is often a prelude to a larger economic crisis. Credit tightens, property values fall, and economic growth slumps. And that could leave emerging markets facing a crisis like the mid-to-late '90s, when currencies plunged, companies defaulted, and it took years to recover. "Currency volatility is anathema to foreign investors," says Robbert van Batenburg, director of market strategy at Newedge. "Foreign investors run for the doors."

It's tempting to look at the MSCI Emerging Market index's 8% drop this year and consider it a buying opportunity, especially now that the emerging markets trade at a multiple of 11.3 times earnings, compared with 16.8 times for the Standard & Poor's 500 (.SPX). Consider, however, that at the end of the 1990s emerging-market slump, U.S. stocks traded at 22 times earnings, while the MSCI Emerging Market index had a multiple of 3.5.

No one's saying it's going to get that bad, but it could get a lot worse than it is now. Unless you're dollar-cost averaging, don't try to catch this falling knife.

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