Emerging Market Contagion

Wild day in the markets. Emerging markets are getting crushed like a 1980s teenage nerd asking the head cheerleader to prom. As I write this, the EEM ETF is down roughly 3% on the day, and down more than 7% over the past week.

We’re past some simple mid-summer-illiquid shenanigans and definitely into the biting-on-the-pillow stage.

So what’s going on?

Well, some might blame EM market weakness on the debacle in Turkey, and although I am sure that’s not helping the situation, Turkey is a symptom – not the cause of recent EM problems.

Understanding how we got here

To understand what’s happening, we need to back up to the 2008 Great Financial Crisis. Back then the U.S. was the epicenter of the problems. Although the rest of the world wasn’t immune to the real estate madness, there can be no denying where it originated. America was patient zero. When the virus started spreading, faced with a financial system that was about to grind to a halt, the Federal Reserve embarked on a massive liquidity pump that flooded global financial markets with an unprecedented amount of US dollars.

It’s quaint to think about this now, but there was a time when emerging markets were complaining about the tremendous amount of US dollars sloshing around. In 2010, Brazil’s Finance Minister, Guido Mantega, scolded the United States and other countries who were “competitively devaluing” their currency through excessive liquidity injections.

At the time, the Brazilian Real was rising to levels that caused considerable economic pain for the Brazilian economy and they desperately wanted the US to ease up on the monetary accelerator.

There was all sorts of talk by finance ministers about the developed nations “currency war” on emerging markets.

The reality is that it wasn’t a “currency war”, but rather a realization that desperate nations do desperate things when they are in trouble. The United States and many of the other developed nations had blown a massive real estate bubble, and when it collapsed, they force-fed liquidity into the global financial system to stop the contagion from spreading.