Canadian investors ignoring the panicked moves by emerging markets' central banks risk having their portfolios blindsided for the fourth time in the past fifteen years.
The South Africa Reserve Bank became the last of the "Fragile 5" emerging markets central banks to raise interest rates early Wednesday morning. This followed an emergency midnight meeting of the Central Bank of the Republic of Turkey that stunned markets by raising the country's benchmark rate by 425 basis points to 12 per cent.
The rate hikes were designed to stem mass capital outflows that present very real risks to S&P/TSX Composite index and the value of the Canadian dollar.
It's too early to tell if the shock and awe central bank moves will stem the tide of emerging markets currency and bond market selling. For now, the Turkish lira and South African Rand are more or less stable against the U.S. dollar.
Canadians should hope it stays that way. It wouldn't surprise me if every single macro-focused hedge fund on the planet had a short-biased position in either the rand or the Turkish lira. If these trades are successful, they will head off in search of the next developing world currency limping behind the herd. The potential prey – which includes Brazil, Indonesia, Mexico, Thailand and Poland – will be much larger and more relevant to global economic growth.
The rising interest rate environment in the emerging markets already presents a significant hurdle to those countries' economic growth. India's benchmark rate has climbed 300 basis points to 10.5 per cent over the past year and Brazil's central bank has upped their benchmark rate by 190 basis points in the same period.
Brazilian and Indian investors will invest less at these rates and foreigners have no interest in exposure to the two countries' unattractive combination of slow growth and sliding currencies. Both nations' economic growth will inevitably slow further.
For Canadian investors, it's not time to panic but a "whistling past the graveyard/Mr. Magoo" strategy is also ill-advised. I've noted previously that Canadian equities have been closely tracking the MSCI Emerging Markets Index. The S&P/TSX Composite is directly in the way of a crumbling emerging markets growth story. Tactically, the longer this goes on, the more cash and the fewer resource stocks Canadians should own.
Long Term Capital Management, the Asian currency crisis, the tech bubble, and the financial crisis are all examples of how global market problems that seemingly have little to do with the Canadian economy can blow big holes in domestic portfolio performance. We're not there yet, but this emerging markets mini-crisis could grow into another example of this unfortunate pattern.
If there was ever a time that Canadian investors could ignore the global economy, that time is long past.
Scott Barlow