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Emerging Markets Contagion Morphs into a Deadlier Pox

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The nightmare scenario: Emerging markets contagion, having mutated into something far deadlier, returns to afflict U.S. equities.

Could the dreaded pox already be upon us? Some are wondering. On Wednesday, the Russian equity market slumped by over 10%, the Mexican peso dipped sharply and Hong Kong's

Hang Seng Index

dropped below 9000.

It's tempting to shrug it all off. After all, the U.S. stock market has shown remarkable resilience when faced with international concerns. Recall


disastrous devaluation of the peso in late 1994 -- just as the U.S. stock market began its three-year sprint. Since Jan. 1, the

S&P 500

is ahead around 12%, despite serious stagnation in


, the collapse of Southeast Asian economies, a near-revolution in


and political instability in



As optimists continue to point out, foreign jitters just send money flooding into


Treasury bills, reducing yields and driving more cash into equities.

But this heartening equation may be growing tired. This week, the U.S. market is looking a lot less insulated. The likelihood of more destabilizing overseas events is increasing. And the market's tolerance for poor economic management in developing countries has just about dried up.

"For the first time the emerging markets are having an effect on U.S. equities," says Bob McKee, analyst at

Independent Strategy

, a London-based market strategy firm that predicted the Asian crisis. "If this continues, we will see a big spiral downwards in all markets -- developed and emerging."

The bears have good arguments for why the U.S. may not be able to ignore international events this time around.

First off, storms are now brewing in every corner of the globe -- not just Asia, though that region is still a crucible of potential market-wrecking events. A quick tour of the trouble spots:

Russia, where the equity market has more than halved in value so far this year, is waging a pitched battle to defend the ruble from devaluation, today ratcheting local T-bill rates as high as 150%. Predictably, market mavens have applauded the move, saying the hike displays an admirable determination to save the currency.

It does. But the experts overlook the fact that Russia has long pushed its luck with the market, ignoring a key lesson of the Asian crisis: Don't let foreign-held debt levels grossly exceed foreign currency reserves.

Now, foreigners own about $20 billion-$30 billion in ruble T-bills, while Russia holds just $10 billion in reserves. This was OK when the country had a current-account surplus that allowed it to provide hard currency to cover foreign debt holdings.

But this year there could be a current-account


-- in the region of $8.5 billion, or 2% of GDP. The government knew this shortfall was coming. But it carried on issuing debt to foreigners. Now, only massive loans from the

International Monetary Fund

can save the ruble, says McKee.

Latin America

could be the source of what one New York hedge fund manager is calling a "silent tsunami."

Investors are leaving the region in droves. There have been outflows from Latin American mutual funds for the past 19 weeks, reducing total assets by 17%, points out Ed Cabrera, Latin strategist at

Merrill Lynch


Within the region,


has been most pumped up by the emerging markets fanatics. But, as with Russia, the government has been a lot more opportunistic, even reckless, than the pundits care to admit.

It let the current account balloon to over 4% of GDP last year. This year the current account will be much lower, because the government slammed the breaks on the economy.

But the budget deficit could rise to a tidy 7% of GDP this year. Brazil's defenders say spending is outside of the government's control, so it can't be blamed. But they neglect to mention that maybe as much as a third of the government's celebrated austerity package, announced last year, hasn't been implemented.

Moreover, last week the government, keen to see a pickup in economic growth ahead of the October elections, lowered interest rates by more than the market expected -- or wanted. "They cut them far too sharply. They badly miscalculated," says one Latin America strategist.

But Brazil is in a Catch 22 that may become its undoing. If the government doesn't loosen monetary policy, the economy will stay in the doldrums, which could give


a poor result in the October presidential contest. He may win only narrowly and have to govern with an even shakier coalition than he has now. Such an outcome would be hugely damaging to the Brazilian market.

You thought 1997 was a bad year for Asia. But 1998 could be just as nasty if


decides to devalue the yuan. "That would be the worst thing the Chinese could do," says Rajeev Bhaman, manager of



Developing Markets fund. "It would send other markets into a big tailspin." Bhaman is not saying a yuan devaluation is likely, and he thinks the selloff in emerging markets is overdone.

But Independent Strategy's McKee says a yuan devaluation will happen before the end of the year. China, he says, needs growth to mop up workers being shed in its deep restructuring of state-owned enterprises, which still employ 65% of the workforce.

Reliable indicators show the economy is growing at around 4.5% per annum, half the official level. McKee argues the country's dictators cannot just postpone the restructuring, as it is necessary to sustain long-term growth.

"We've seen in Indonesia what happens when an authoritarian leader can no longer guarantee growth," McKee remarks.