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Emerging Markets Go From Bad to Worse

NEW YORK (TheStreet) -- After a bad year for emerging markets in 2013, things have gotten worse in 2014.

Last year, the iShares MSCI Emerging Markets ETF (EEM) declined 5%, which wasn't necessarily that bad except that domestic markets were up 30%. So far this year, EEM is down 10%.

The centers of attention are Argentina and Turkey, whose currencies troubles could become crises. The equity markets for these countries can be easily followed by the Global X Argentina ETF (ARGT), down 11% year-to-date, and the iShares MSCI Turkey ETF (TUR), down 13%.

The declines are contributing to broader developing-market declines, stemming in part from the Federal Reserve's reduction in bond purchases.

The bigger story has been the currencies in Argentina and Turkey. The U.S. dollar has rallied 23% against the Argentine peso this year and 1.8% against the Turkish lira. Bespoke Investment Group notes that the Turkish lira has lost 34% against the U.S. dollar over the last year.

The central bank of Argentina last week decided to no longer intervene to defend the peso, and this week the focus has shifted to Turkey, whose central bank took the opposite approach, appearing to go all in to defend the lira. The Turkish central bank has taken the extreme step of huge interest rate hikes in several benchmarks, including increasing the one-week lending rate for banks from 4.5% up to 10%.

Looked at in isolation, raising interest rates usually strengthen the currency because higher rates means higher interest earned on deposits in that currency. Rates hikes, however, don't occur in isolation; they have consequences. When interest rates are high, they tend to impede economic growth because access to capital becomes more expensive.

The rate hikes in Turkey may force other emerging-market countries to also raise rates so that their currencies can remain competitive. This week, South Africa has raised its main interest rate to 5.5% from 5%.

Armed with some understanding of the situation, investors can consider how to proceed in their portfolios.

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