U.S. stocks tumbled Friday to their biggest loss in more than seven months, extending a global selloff that investors fear signals turmoil to come as financial markets adjust to a pullback in central-bank stimulus.
The declines extend a dark beginning of the year for equity investors world-wide, a jarring drop for markets that climbed imperviously through 2013.
The Dow Jones Industrial Average fell 318.24 points, or 2%, to 15879.11. The Stoxx Europe 600 lost 2.39%, and Germany’s DAX, down 2.48%, had its sharpest fall in months. The Nikkei also fell 1.94%.
While those drops were dramatic, much of the pain of investors’ readjustment is landing on developing economies, from Brazil and India to Thailand and South Africa.
In recent years they were buoyed by the high tide of cash from the U.S. Federal Reserve’s stimulus and by China’s voracious growth.
Now, those forces are receding, with the Fed expected to reduce monthly bond purchases again on Wednesday.
Investors are pulling back with them.
“We’re looking at how U.S. policy will hurt the emerging markets,” said Robert Glownia, quantitative analyst at RiverFront Investment Group, which manages about $4.1 billion in exchange-traded funds. “We don’t think the tail is going to wag the dog.”
Michael Ganske, head of emerging markets at Rogge Global Partners in London, said he sold currencies this week of countries such as Thailand and Chile that export heavily to China. On Thursday and Friday, emerging-market currencies dropped after a report showed a manufacturing slowdown in China.
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“When you have hiccups in a big market like China, that will have a direct impact on global growth and export demand for many developing countries,” Mr. Ganske said. Rogge has $58 billion in assets under management.
Most investors—Mr. Ganske among them—are confident that emerging markets’ long-term growth will outpace that of the developed world. Economic progress marches onward. Middle classes blossom.
But navigating the short term is difficult. Slowing growth in China could crimp demand from goods and services from its trading partners.
At the same time, a shifting Federal Reserve policy could alter the tides of capital flowing through the world economy. As the Fed has pumped dollars into the U.S. financial system to boost growth at home, waves of investment money have flooded into markets overseas in search of returns that beat exceptionally low U.S. interest rates, pushing up prices there.
Now, as the Fed steps back, the prospect of higher returns in the U.S. promises to pull that money back in. Investors in emerging markets are struggling to figure out how much compensation to demand for their risks, especially in economies that appear weak.
That has been on display for months in Turkey, where a political corruption scandal and weak economic fundamentals have combined to punish the Turkish lira. The central bank has been unable to arrest its slide, and investors in Turkish assets are sitting on big losses. The lira slumped almost 2% Friday, to 2.34 per dollar.
Other emerging-market currencies, including the Peruvian sol and the South African rand, suffered as well. Stocks have taken a hit, too. Turkey’s main stock index is down 4.4% in the last two days; Brazil’s Bovespa is down 3.1%. A widely traded emerging-markets bet, the iShares MSCI Emerging Markets exchange-traded fund, is down 5%.
The rout has left Paul Zemsky, chief investment officer of multiasset strategies for ING U.S. Investment Management, wondering whether he could unload more emerging-market holdings. He initially cut his emerging-markets exposure in the fourth quarter of last year.
“It’s too early to buy emerging markets, but it’s probably too late to sell,” said Mr. Zemsky, whose firm manages $200 billion.
Friday’s swoon was notable for its breadth—nearly all major equity markets were in the red. In foreign-exchange markets, the selloff began with currencies such as the South African rand and Turkish lira that have been viewed as vulnerable because of sluggish domestic growth. But it soon spread to currencies of countries with relatively solid fundamentals, such as Mexico’s peso and South Korea’s won. Currencies also slid in Eastern Europe.
Some investors were wary of calling it panic just yet. “It remains to be seen whether the weakness deepens or contagion spreads further but much will depend on institutional investor flows,” said Nima Tayebi, emerging-market currencies portfolio manager for J.P. Morgan Asset Management. “So far there is nervousness but little signs of outflows.”
Officials from the U.S. Treasury and the International Monetary Fund declined to comment Friday on the market turmoil. But top officials from the IMF, the World Bank and Treasury have been warning about the risk of volatility in emerging markets, particularly those with weak economic fundamentals.
The developments over the last several days aren’t a surprise, said Hung Tran, executive managing director of the Washington-based Institute for International Finance, which represents big banks, insurance firms, hedge funds and pension funds.
“This brings to a head vulnerabilities that have been building for some time,” Mr. Tran said.
Several big emerging-market countries, Turkey among them, are running large deficits with the rest of the world—on a broad measure they import more than they export. That makes them dependent on financing from abroad to make up the difference.
As investors become less likely to provide it, the countries get squeezed. One way to right the balance is to increase exports, but China’s deceleration makes that tough for its competitors and trading partners. A weaker currency is another option—it both potentially sparks exports, making them cheaper on world markets, and discourages imports, which get more expensive at home—but it comes at the cost of boosting payments on foreign debt.
Investors in a country’s bonds, attuned to that spiral, pull out. That pushes harder on the currency.
Buying emerging-market stocks is also tricky because of the risk of losing money on currency fluctuations. Indeed, emerging-market stocks have floundered for years. The MSCI emerging markets equities index, priced in dollars, stood Friday at close to its level of four years ago. The Dow is up more than 50% in that period.
Some investors believe more comparative weakness is in store as the Fed withdraws its stimulus, known as quantitative easing, or QE. The U.S.’s recovery appears sturdy—which, after all, is why the central bank feels comfortable paring back.
At the same time, a slowdown in the growth of U.S. company earnings is raising some concern among investors, despite generally solid fourth-quarter numbers so far.
“Because the Fed was full speed on QE last year, some of these blemishes were pushed to the background,” said Peter Boockvar, chief market analyst at the Lindsey Group, an economic advisory firm. “Once QE goes away, these will come back into focus.”
—Alexandra Scaggs and Ian Talley contributed to this article.
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