Dow Plunges: Why Emerging-Market Currencies Could Crush the Bull Market

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

The Dow Jones Industrials plunged 318 points on Friday, bringing its loss for the week to almost 580 points and awakening fears of even bigger potential losses in the near future. Yet even though calls for a Dow correction are premature, the lesson that Dow investors should take from the past week's carnage is that no matter how strong the U.S. economy's recovery is, those who own U.S. stocks can't afford to ignore what's happening even in obscure financial markets like emerging-market foreign exchange.

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What's happening in emerging markets?
Most investors were able to understand quite easily why the Dow dropped 176 points on Thursday. News from China that its manufacturing sector might have begun to contract in January had a clear impact on stocks around the world, as China has played a substantial role in supporting the global economy throughout the past 15 years. Even the slightest slowdown in the country's impressive growth rate has sent markets into fits in the past, and so the prospect for a true recession in the world's second-largest economy was enough to send legitimate warning shots across the bow of the U.S. stock market.

But Friday's declines were somewhat harder to understand from an intuitive standpoint. References to record lows in the value of the Turkish lira and the 12% devaluation of the Argentine peso by the South American nation's central bank don't have as much immediate connection to U.S. investors, making Friday's Dow plunge seem less justifiable. After all, Turkey's stock market has been dropping for months, with the iShares MSCI Turkey ETF having lost almost half its value just since last May. Even the drop in the South African rand to its lowest level since 2008 doesn't entirely resonate with U.S. investors, despite the well-known importance of South Africa in the precious-metals markets.

It all comes back to central banks
The concern that developed-market investors have is that these relatively small emerging-market economies are the canaries in the coalmine of the larger global economic community, and that stresses that hit them first could easily spread to larger economies. Just as Europe worked hard to contain problems in Greece and Cyprus to make sure they didn't spread to larger economies like Spain and Italy, so too are world central banks in a position to have to figure out how to keep Argentina's devaluations from affecting Brazil, or Turkey's currency crisis from destabilizing the entire eastern European bloc.

More importantly, investors have become increasingly convinced that while the removal of monetary stimulus from the Federal Reserve might not have a catastrophic impact on U.S. stocks, it could hurt emerging markets. Essentially, what the market is saying is when developed market nations remove liquidity from their monetary systems, the first place that asset owners will sell is in risky emerging-market investments. That became clear throughout 2013, as the iShares MSCI Emerging Markets ETF and many other emerging-market stock investments failed to participate in the global bull market. The geopolitical and global economic ramifications of that fact will add yet another level of complexity to the thought process that central banks are already struggling to navigate in their efforts to get the global economy back on an even keel.

Keep your eyes open
You don't have to look hard to find Dow stocks that will suffer from emerging-market instability. Consumer giants Coca-Cola and Nike see emerging and frontier markets as major growth opportunities, with every possibility of boosting sales to a greater extent than they can in more mature markets in the U.S. and Europe. Big-oil leaders ExxonMobil and Chevron rely on political stability in the corners of the world where they search for new oilfields, and problems can lead to production shortfalls that threaten their ability to maintain revenue levels.

But the broader question is whether a financial crisis in emerging markets has systemic risk for the entire global economy. At this point, the smaller countries involved probably don't have the capacity to create a systemic failure. Without addressing the situation adeptly now, though, the risk of contagion will only grow and could eventually threaten the gains that investors have fought hard to win over the past five years.

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Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool recommends and owns shares of Coca-Cola and Nike. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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