The Dow Jones Industrial Average ended 2013 at a new all-time record, and the S&P 500 reached its all-time closing high two weeks later. The Federal Reserve is confident enough that in December it announced it would begin reducing the bond purchases that have helped fuel economic recovery.
But fast-forward to the end of January and things look a little different. The Dow lost 5.6% during the month--its worst January since 2009--and the S&P 500 went from an all-time high to a monthly loss in just over two weeks. What in the world has been going on?
As it turns out, "what in the world" is exactly the right phrase. The recent turmoil demonstrates just how tightly linked global markets are now. The shift in Fed policy coupled with internal problems in a number of emerging-market countries have given financial markets around the world the jitters. After 2013's stellar run for equities, many investors have decided to back away from risk for a while, and that has hurt not only emerging markets but also U.S. stocks.
If you're unclear about why a headline like "Argentina devalues its peso" can have an impact on equities around the world, you're not alone. Here's a brief look at how Fed policy and emerging-market currencies have combined to wreak havoc on global markets recently. Good news, bad news from the Fed
Since November 2008, policies by both the Federal Reserve and other central banks have kept interest rates low; to combat the recession, they injected money into the global economy and made it easier to obtain credit. Emerging markets benefitted from that easy money. Investors who grew impatient with the Fed's historically low interest rates turned to investments paying a higher return. In many cases, those investments were overseas, and that influx of money helped fuel growth in emerging markets.
However, that dynamic began to show signs of reversing last June after the Fed announced its plans for winding down its economic support. Investors who had sought the higher interest rates that emerging markets had to pay on their debt began to rethink their strategy, anticipating the end of rock-bottom rates on U.S. Treasuries and a stronger dollar. Once the Fed actually began cutting its bond purchases last month, currencies such as the Brazilian real, the Indian rupee, the South African rand, and the Turkish lira began to lose value even more rapidly. As a country's currency weakened and each real or lira bought less and less, higher prices set in, especially for goods valued in stronger currencies such as the dollar.
That kind of inflation, coupled with high budget deficits in many cases, has contributed to political instability in some countries. Many emerging-market leaders have been faced with a difficult choice. Do they raise interest rates to try to fight inflation and keep investment assets from leaving the country for bigger returns elsewhere--at the risk of hurting what may be an already fragile economy by making credit tougher to get? Or do they devalue their currency further, hoping that less-expensive exports will improve sales, but also risking greater inflation and the anger of citizens suffering from soaring prices? That uncertainty has brought on double-digit losses in the stock markets of some developing economies such as Brazil and Turkey.The Fed isn't the only reason for emerging-market problems
The beginning of tighter Fed policy in January was followed by a second trigger for the current turmoil: a survey of purchasing managers in China that suggested that the manufacturing sector there was slowing. China has announced plans to rein its so-called "shadow banking" system--unregulated lending that has helped fuel a frenzy of development there in recent years. China's manufacturing sector, which serves as the factory floor for much of the world, is an important customer for the commodity exports that are vital to many emerging economies; lower demand for commodities could have a substantial impact on countries whose economies depend on exporting them. If Chinese manufacturing catches a cold, economies that depend on exports to those manufacturers could get the flu, and the disease could take the biggest toll on countries whose economies are already sick or that have low reserves of U.S. dollars in their coffers.
Concerns about such problems have come to a head in the last few weeks as countries have taken various approaches to try to deal with their problems. Argentina stunned global markets when it devalued its peso by almost 20% in an attempt to help pay the country's debts, while Venezuela imposed indirect currency controls. Turkey nearly doubled its key interest rate, while central banks in Brazil, India, and South Africa also have raised interest rates in the last couple of weeks. Why does any of this matter to U.S. equities?
There are two reasons why the turmoil in emerging markets has had an impact domestically. First, many large U.S. companies derive a substantial percentage of their revenues overseas. Weaker currencies abroad can cut into those companies' revenues as American goods become more unaffordable for customers overseas and sales made in a weakened currency are worth less to a company's bottom line. Headwinds from exchange rates and lower sales could affect corporate profits.
Also, it wasn't so long ago that global financial institutions were at serious risk of being hurt by bad investments in struggling countries. Memories of Greece and other struggling eurozone countries in 2011-2012 are helping to fuel a global "risk off" mentality among investors already on edge about how aggressively the Fed will tighten and how the U.S. economy will respond.Keep some perspective in the face of turbulence
The events of recent weeks are a reminder that emerging markets are typically more volatile than those of more developed economies, and that in addition to being subject to the usual risks that apply to all equities, foreign investments are subject to the currency and political risks that are an inherent part of investing internationally. However, it's also worth remembering that the International Monetary Fund recently raised its forecast for global economic growth this year to an annual rate of 3.7%*. Also, one of the reasons for the Fed's monetary tightening is that its outlook for the U.S. economy is more encouraging. The Fed also has left itself plenty of room to maintain its support; in 2010, it halted bond purchases because the economy was growing, only to renew them a couple of months later. The Fed won't meet again until the end of March, so markets will have a little time to digest its most recent decision.
Don't let every twist and turn derail a carefully constructed investment game plan. If you're focused on a long-term goal, remember that your personal circumstances are just as important as external events, and ups and downs in the market are to be expected. Though the S&P 500 lost 3.6% in January, that came on the heels of a 29.6% price gain in 2013, and many experts have argued that some retrenchment in an almost five-year bull market is to be expected. However, it might be worth exploring how various asset classes in your portfolio could be affected by Fed actions and global volatility, and whether there are ways to hedge your exposure. And if you've been keeping a substantial cash position, volatility also may present buying opportunities.
*World Economic Outlook Update, January 2014, www.imf.org, as of 2/3/2014.