This is the last emerging market crisis story for a while, promise. But one angle – exactly how a plunging currency in a far-off place affects supposedly stable markets like the US – is worth exploring because it’s happening right this minute.
Let’s start with the choices facing an American or European investor who needs a decent return, but who finds that interest rates have fallen to the point where traditionally safe things like bonds and bank accounts no longer yield enough.
Such an investor has two choices: 1) Stick with what they know and accept sub-par returns (which might mean being fired if you’re a pension fund manager, or – if you’re a retiree – having to spend your golden years as a Walmart greeter), or 2) Branch out into more exotic but higher-yielding instruments and hope for the best.
Option number 2 has been pushed by financial planners and pension advisors for the past few years, with emerging market securities being the exotica of choice. The sales pitch went something like this: Developing country stocks are cheaper relative to earnings and dividend yields than their rich country counterparts, while their bonds yield quite a bit – frequently two or three times – more than US Treasuries for only marginally more risk, so they’re a great way to diversify while goosing returns.
Many, many investors swallowed this and bought emerging market stock and bond funds. And for a while they reaped the promised high returns, allowing retirees to spend time with their grandkids and pension managers to keep cashing their massive paychecks.
Then – in part because of all the hot money flowing in from credulous First World investors – the emerging market countries started to veer off course. They borrowed trillions of US dollars and, when the dollar started rising against their domestic currencies, went into tail-spins of varying severity. And now tens of thousands of American investors who couldn’t settle for 1% returns are looking at double-digit losses.