While emerging markets gyrations have stolen the headlines, they aren't the sole cause of the slump. Some weaker economic data in the U.S., disappointing corporate earnings and the Federal Reserve's continuing reduction of its economic stimulus have also hurt stocks.
This is what analysts are saying about emerging markets and how they will impact the U.S. market.
WHAT IS DRIVING THE TENSIONS IN EMERGING MARKETS?
Emerging markets are plagued by a number of worries.
Growth in China is showing signs of slowing, as the nation transitions from an export-driven economy to one that is fueled by demand from Chinese consumers. A more severe slowdown would have ripple effects, for example, hurting demand for commodities and crimping growth in other Asian nations that rely on trade with China.
"People were overestimating emerging-market growth coming into the year," says Alec Young, a global equity strategist at S&P Capital IQ. "Stocks had to move down to reflect the more modest reality."
Investors are also reacting to further cuts in the Fed's stimulus program, which involves buying billions of dollars of bonds each month to drive down long-term interest rates. Policy makers announced last week that they would further reduce their purchases by $10 billion to $65 billion, starting in February.
The low long-term rates in the U.S. had pushed investors to look for higher returns overseas. The easy money boosted growth in developing nations and reduced the impetus for economic and political reform.
Now that interest rates are expected to rise in the U.S., investors are pulling back their money.
HOW SERIOUS ARE TENSIONS IN EMERGING MARKETS?
So far, few analysts see recent events as a rerun of the 1997 Asian financial crisis, the last time that turmoil in emerging markets shook the global financial markets.
Compared with 1997, emerging-market economies have less debt and stronger current account balances, the measure of the value of goods that they import versus the value of goods they export, says Mark Edwards, who manages an emerging-market stocks fund for T. Rowe Price.
Many developing nations also have freely traded currencies now, rather than currencies whose values are fixed against the dollar. Even though the Turkish lira and the South African rand have slumped against the dollar, the declines should help those economies address imbalances.
"The currencies are already taking a lot of the strain," says Edwards of T. Rowe Price. "They act as a safety valve."
A weaker currency means that a nation's exports will become cheaper, boosting demand. At the same time, imported goods will become more expensive, forcing domestic consumers to use cheaper, locally produced alternatives.
Emerging-market economies should also benefit if the U.S. economy continues to strengthen, even if that means the Fed reduces its stimulus further. That's because higher U.S. growth should lead to higher demand for exports from emerging markets.
HOW MUCH DAMAGE COULD THE TURMOIL DO TO U.S. STOCKS?
Not that much.
The economic recovery in the U.S. is strong enough to withstand the turmoil, says Russ Koesterich chief investment strategist at BlackRock.
The economy grew at an annual rate of 3.2 percent in the fourth quarter of 2013, on the strength of the strongest consumer spending in three years. Expectations are rising that 2014 will be the best year for the U.S. economy since the recession ended 4½ years ago.
"The fundamentals in the U.S. remain sound," says Koesterich. "I don't think anything that has happened so far represents a systemic risk to the global economy."
U.S. stock investors should pay more attention to what's happening at home. A big-sell off in stocks Monday was driven about concerns about manufacturing growth in the U.S. rather than emerging markets, Koesterich says.
Analysts at Goldman Sachs estimate that U.S. companies derive just five percent of their profits from emerging markets, limiting their impact on U.S. corporate earnings. The U.S. economy is a relatively closed economy, which relies on domestic consumption, not the rest of the world for its growth, analysts at JPMorgan Asset Management wrote in a note Friday.
A couple of ripple effects from emerging-markets should benefit consumers in the U.S. and help the economy maintain its recovery. For instance, lower demand for commodities from emerging markets could push down oil prices, benefiting the U.S.
As stock-market volatility increases, so does demand for safer assets like U.S. Treasury notes. The yield on the 10-year Treasury note was at 2.63 percent on Tuesday, close its lowest level in three months, and sharply below its 3 percent level from the start of the year.
Lower interest rates mean lower mortgage rates and stronger demand for housing.
"Consumers are going to have more money in their pockets because interest rates are lower," says Sammy Simnegar, who manages Fidelity's International Capital Appreciation Fund. "You have to be bullish on the U.S."
WHY DID U.S. MARKETS REACT BADLY TO THE NEWS FROM EMERGING MARKETS?
After a big run-up last year, many investors were concerned that stock prices were becoming overvalued. The slump in emerging markets prompted them to sell.
Last year, the S&P 500 logged its best gain since 1997, ending the year up almost 30 percent. Stocks surged 10 percent in the fourth-quarter alone as investors grew more optimistic about the outlook for growth in 2014.
"U.S. stocks were very overbought coming into the year," says Young at S&P Capital IQ. "There was a lot of complacency. Everybody loved stocks, so they were more vulnerable to any bad news." (AP)
