MORNING BID – The prime directive

January 30, 2014

So, it’s been a few days. Which means the markets have hit that point in the Star Trek episodes when the Klingons were temporarily short of torpedoes, which gave the Enterprise crew time to suss out what was going on.

Some of the missiles were fired. Big rate hikes from Turkey and South Africa, that followed a rate hike from India, and a few conclusions are inescapable:

  1. The selling hasn’t run its course yet
  2. Rate hikes aren’t enough to turn the tide in favor of a struggling currency because people extrapolate that higher rates are going to pinch growth
  3. People may have been holding out hope that the Federal Reserve would have nodded in some way to the emerging markets and got no quarter from Ben Bernanke as he dropped the mic and disappeared in a puff of smoke at his last-ever Fed meeting.

Add in the latest – a decline in China’s manufacturing – and the pullback certainly has not run its course. Overnight volumes and trading during the NY cash session showed once again that the better volumes have been on the selling, rather than the buying.

The question now is how far this can go? And that depends on what kind of developments we’re looking at. If there’s a massive flight of capital, the selling will remain indiscriminate, and long-running. It’s not too encouraging that the Turkish lira’s rally was good for a few hours and not much more, and nobody even tried to take the South African rand that much higher at all.

But let’s hold fast on the ‘contagion’ notion for a bit here, because ‘contagion’ does not simply mean ‘a whole load of people selling stocks.’ So we’ve seen actions from central banks in India, Turkey, South Africa and earlier Indonesia, and Citigroup suggests Russia could take surprise action in a couple of weeks as well. Having central banks take the initiative to force adjustments in policy is preferred on some levels to the damage markets can dish out (though markets can keep dishing it out also).

But the true measure of contagion relates to how quickly short-term funds leave a country, how much of a country is dependent on foreign funding of longer-term obligations (do foreigners own all the short term debt? If so, not good – Turkey’s short-term external debt is equal to 116 percent of its FX reserves, leaving it unable to defend against capital flight, according to Morgan Stanley,) current account balances, and a few other factors. In a note late Wednesday, Morgan Stanley threw in China exposure to the mix as well, noting that those exporting lots of commodities – be it fuel, metal or ore – are in a more precarious position.

The more troubled nations when it comes to debt issues – like Brazil, Turkey or South Africa – are a bit less exposed to China than Malaysia or South Korea, but they’re plenty exposed, and the latter two don’t have problems with current account deficits and as much in the way of short-term funding. Closer to home, Goldman Sachs notes that just 5 percent of S&P 500 sales derive from emerging markets, and that during EM selloffs, the S&P tends to fall about half as much – with the most exposed naturally being materials and energy sectors.

So there’s some comfort on the U.S. side of things. Still, with US growth not helping emerging markets and China’s slowing and adjustment to the debt it has in its economy weighing heavily, the contagion problem is a very real one that may rear its head in a bigger way. If a slew of rate hikes can head off massive capital flight, the slow growth that comes from higher rates may be something individual economies can deal with. However, that’s only if this is enough of a confidence-inducing measure to keep investors somewhat invested. That’s a big ‘IF.’

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