How a U.S. Downturn May Affect Emerging Markets

Includes: ADRE, EEM, VWO
by: Mohammad Farooque

The subprime mess is getting uglier and uglier every day as it spreads to more stable parts of the financial system. The big question is how much this will affect the U.S economy, developed world economy and the so-called "third world economy", which has been upgraded to "emerging markets" lately.

Since the world economy is interdependent, as we all live in a global village, financial turmoil in one region will affect other regions, albeit in different ways. There is a well known pattern that on those days that the U.S stock market falls, the rest of the stock markets around the world fall too; and if the U.S stock market goes up, the rest of the world markets also move upwards. However, in my opinion, this a psychological dependence and sooner or later a decoupling of U.S markets and other markets will take place. I will argue that real interdependence of the past has more or less led to this psychological dependence over time.

Around half a century ago, the third world was heavily dependent on the developed world to generate a major part of their revenues, whether it was selling their raw materials to the developed world or exporting low cost/labor intensive goods or "political loans" in the form of so called "economic aid". In return, the developed world manufactured high tech products e.g. automobiles, heavy machinery etc. and exported it to third world. During those times if the economic cycle slowed down in the western world, then the third world went down too.

Time changed and the high tech manufacturing started moving to third world countries because of rising labor cost. Now times have changed even more - developing countries are producing both low cost/labor intensive goods as well as competitive high end products. The trade among third world countries is on a steady increase. In my opinion, the world economy is in the process of taking an important turn.

Here are two potential case scenarios regarding a financial crisis in the U.S and the resulting possibility of a slowing economy:

1. Economic slow down resulting from financial crisis will lead to less purchasing power of the consumer, leading to less importing of goods from emerging economies, leading to the slowing down of those economies, leading to decreased productivity and poor performance of companies. That will ultimately affect the stock prices in emerging markets. Meanwhile, the Fed will lower the interest rates to offset the slowing of economy leading to more borrowing from businesses to stimulate the economic cycle. Stimulation of the economic cycle will lead to an influx of investments in the U.S, which will ultimately boost the value of dollar denominated assets. To me, this is a very unlikely scenario.

2. The Fed decreasing interest rates futher will lead to a shifting of capital from dollar denominated assets to other alternatives, including investing in emerging markets by foreign investors who are already getting less return on their investments because of the gradual decline of the dollar, leading to further depreciation of the dollar. I must point out that initially lowering the interest rates and issuing extra billions of dollars worked temporarily for the U.S economy, however it is more likely that such moves will be counter productive and harmful for the economy in the long run.

I am sticking with my previous assumption that emerging markets will keep doing better than developed markets for several years to come before an equilibrium will be established. For reasons I discussed in previous articles, I will remain heavily invested in emerging markets.

Disclosure: Author is invested in emerging markets.