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Bob’s View: Emerging concerns

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By Bob Landaas

Let’s talk about the contagion that’s spreading in the emerging markets. We’ve seen the currencies in Turkey, South Africa and Argentina among others getting clobbered.

Two things set it off. One was a report showing Chinese manufacturing had contracted for the first time in six months. A lot of these emerging markets transport raw materials to China. The orders are slowing down. As a result, the emerging markets are struggling.

And then, the double barrel of the shotgun came when the Fed reduced its bond buying by yet another $10 billion. The emerging markets are heavily dependent on borrowed money from abroad. And as their cost of doing business goes up, their lending dries up, so they got hit again.

Concerns over the emerging markets aren’t all that’s behind the broad stock sell-off to start 2014. We had expected some kind of selling coming into the new year – a bit of profit taking. We knew all sorts of people who didn’t want to pay tax on capital gains until the new year.

And let’s remember, stocks don’t just go up. We haven’t had a correction of 10% or more in more than two years. So it isn’t a matter of if. Corrections come.

But the headline explanation for the drop in stocks has been the flight of investors from emerging markets, especially the so-called Fragile Five: Brazil, India, Turkey, South Africa and Indonesia.

They’re heavily dependent on exporting raw materials to China. When China slows, so does the emerging world. They’re also heavily dependent on borrowing money. That has been easier for them since the Federal Reserve has been keeping interest rates next to nothing and plowing trillions of dollars into bonds to stimluate the U.S. economy.

But now with the Fed tapering its stimulus, the cost of borrowing is going up for the fragile economies.

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The reality is that a lot of money has poured out of the emerging markets. The reality is those markets are going to find financing more difficult. Look what happened in Turkey, as an example.

Turkey raised its overnight lending rate 4.25 percentage points. But it only held the currency for 24 hours. Because then the Fed announced its next round of tapering. So a huge increase in Turkey’s overnight rate wasn’t even enough to put a finger in the dike in the sell-off of the Turkish lira.

I think at the end of the day, the selling will subside when people realize contagion is not going to spread to the developed world. I think the selling will subside when people realize that the wheels aren’t coming off the cart, that China is still going to be importing the raw materials – although maybe not at the same rate.

The boom years for the emerging world are over, at least for a while, but those markets had really benefited from easy money policies in the United States.

Turkey is widely viewed as the big emerging market in that part of the world. It’s important to get a sense of that in context. The Turkish economy isn’t any larger than the economy of Los Angeles. Not to belittle the efforts of the Turks, but their economy is a fraction of the developed nations of Europe, let alone that of the United States.

It’s good to put it in perspective. People can get twitchy pretty quick when they start reading the word “contagion” in the newspaper. A lot of investors have pretty good memories of the 1997 Asian financial crisis and how quickly it spread and then the sovereign debt crisis that we all struggled with the last two years in Europe.

What really matters when you invest your money is interest rates and earnings.

The times that I start to worry aren’t when the markets sell off 5% after a 30% run last year. Five percent is a normal pullback. Frankly, it’s healthy for the markets.

The times when you want to worry are when earnings are cascading lower and when interest rates are spiking higher.

After five years of relentless cost-cutting, this is the fourth year in a row that the S&P 500 hit record levels of profit. Earnings are supposed to go up 8.5% this year and 10% next year. Those are big numbers.

Margins are the highest they’ve ever been because commodities prices have been coming down for 25 months in a row, and interest rates are low. It’s inexpensive for companies to borrow.

This emerging market sell-off will blow over at some point. When it does, we’ll resume our upward course in the markets.

Bob Landaas is president of Landaas & Company.

(initially posted Feb. 5, 2014)

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