Key News

- European Central Bank council member Axel Weber said Greece's fiscal crisis is threatening grave contagion effects in the euro area, justifying Germany's contribution to a 110 billion-euro ($142 billion) aid package. (Bloomberg)


History is mostly guessing; the rest is prejudice

Will Durant

FX Trading - If you utter the C-word than the words emerging markets must come next Mr. Market finally waking to the systemic global macro threat that was always lingering in the background of Eurozone debt default? Yes indeed, he said.

There is much talk of the dreaded C-word in the financial press this morning-CONTAGION! Keep in mind, if you utter the word contagion the words emerging markets (EM) must come next.

But why should EM get hit? They are doing so well.

We are told by analysts of all stripes how EM represent a virtual sea of tranquility there for us to ride out any storm (we heard that before the credit crunch reality too-it's the decoupling thing.) In fact, none other than Standard and Poor's (yes, the same guys who worked overtime collecting sweet fees for stamping AAA ratings on junk securities during the free-credit era of past) says EM bonds in Asia should be considered a haven for contagion fears. And boy, if we can't trust S&P to tell us the right stuff, who can we trust.

EM stocks took it on the chin along with everyone else yesterday, with the MSCI Emerging Markets Index breaking below its 55-day moving average and daily trend going back to Feb 2009:

Let's conjecture for just a moment about the two main events we have been talking about here for a while, off and on; 1) The collapse in Eurozone demand; 2) A slowdown at the margin (at least) in the torrid growth in China. Both would suggest the demand for raw materials, at least at the margin, will wane. Copper is already getting hammered on concern China demand will ease. EM growth is still predominantly intertwined with commodities; thus the tight correlations between EM stocks and commodity indices.

The chart below shows EM stocks, CRB Index, and Copper:

It may just be a passing concern indeed. One day of risk aversion i.e. profit taking and loss making, doesn't make a trend you might say. And you would be correct. But what concerns us is the background funding of said EM markets. It is the funding link that creates the contagion problem.

No matter the many virtues of EM, and there are many, we still live in a world where the center provides funding to the periphery. We have highlighted this relationship in the chart below, which was part of a webinar we did back in November regarding emerging market currencies.

There are a lot of moving parts in the chart above, as we tried to provide a representation of the center vs. periphery relationship. The key point is that EM still draws on the developed world liquidity pool for funding. This is why contagion plays such big role for EM. They lack their own domestic source of funding, for the most part. That is starting to change, and will change as EM continue to develop.

Thus, circling back to the Eurozone, the PIIGS problem, at the core, is a Eurozone banking problem. That is why the IMF was called in. They needed the big pool of US taxpayer money, and that of many other countries taxpayers outside of Europe, to be used now to save European banking system. Period! If the European banking system gets into trouble, they pull credit lines first from where? Right, the periphery; it's why Central European currencies got hit especially hard yesterday. This pulling of credit lines to save the center is what leads to contagion across emerging markets that don't appear to be in trouble or related.

So, just keep that in mind when the likes of S&P or any other EM cheerleader tries to tell you emerging markets are a sea tranquility.

Jack Crooks