Investors Cry Over Argentina as Contagion Fears Resurface

Emerging markets have descended into chaos in recent days as investors worry about the fallout of Fed tapering and grapple with ineffective governments.

Nowhere are those concerns more clear than in Argentina, which in recent days has become the epicenter of emerging-market turmoil as its currency has plummeted 20% this month alone.

The trouble in Argentina and other emerging markets appears to be having a spillover effect on developed markets like the U.S., where the Dow Industrials are on track for their worst week in eight months.

“Companies and investors that deal in emerging markets also deal in developed markets’ stocks. When crazy stuff happens, correlations approach unity. We forget this over and over again, and at our own peril,” Michael Block, chief strategist at Rhino Trading Partners, wrote in a note to clients on Friday.

It’s not just Argentina that is causing investor angst. Emerging-market fears were sparked earlier this week by alarming manufacturing numbers out of China. At the same time, Venezuela remains in free fall, the Turkish lira has tumbled to a record low and the currencies of Russia and South Africa are sitting at levels unseen since the financial crisis.

“The volatility injected into the system has undermined confidence in emerging markets,” said Block.

(Click here to read more on whether it's too early to call this a market correction)

All Eyes on Argentina

But Argentina has become the focal point given the Latin American country’s dwindling foreign-exchange reserves and the dramatic deterioration of its currency.

Buenos Aires finally took action on Friday, surprising the world of finance by relaxing currency controls after months of refusing to do so. The government devalued the currency by 12.7%, the biggest such move since 2002, according to Nomura.

“It is an implicit recognition that there is a problem with the currency and that the authorities appear less willing to continue burning reserves,” analysts at Nomura wrote in a note on Friday. “This is a very risky strategy. The devaluation is being carried out without any macro anchor behind it. The fiscal deficit is increasing and monetary financing of these deficits is rising.”

Argentina’s peso has plunged about 20% this month alone, including a nosedive on Thursday that was the currency’s biggest one-day decline in more than a dozen years.

“Equities are in free fall as fears over Argentina’s stability have sent shockwaves throughout global markets."

- Dave Madden of IG

Like other emerging market currencies, Argentina’s peso has been under pressure from less easy monetary policy from the Federal Reserve. While the Fed insists its dialing back of quantitative easing does not amount to policy tightening, the moves do have the effect of making markets less liquid.

"QE covers up all the warts and blemishes and once it starts going away, they all come to the surface,” said Peter Boockvar, chief market analyst at The Lindsey Group.

Rampant Inflation

But the problems run deeper than simple Fed fallout for Argentina, which has been crippled by debilitating inflation. Analysts, who don’t trust the country’s official pricing statistics, believe Argentina’s inflation surged around 25% in 2013 and project another 30% increase for consumer prices in 2014.

This has put pressure on Argentina’s foreign-exchange reserves, which tumbled 30% in 2013 and fell to $29.3 billion on Thursday. That’s good for the lowest level since late 2006.

Gross domestic product growth topped out at 8.3% in the second quarter of 2013, but then receded to 5.5% in the third quarter and is expected to come in around 2.5% for the fourth quarter.

“The central bankers and the government in Argentina have been in a long standing battle to decide who is more incompetent. I’d say they both win,” said Block.

Few Rescue Hopes

Argentina doesn’t appear to have many obvious options for a rescue. It is unlikely to accept tough conditions from the International Monetary Fund, which it has a difficult history with. Venezuela, which has helped in the past, is mired in its own difficult situation caused by increasingly radicalized economic policies.

That may lead Argentina to try to tap the international capital markets, but it’s not clear anyone wants to go near the country’s debt.

According to Markit, the annual cost to insure $10 million of Argentinean debt for five years jumped 5.7% on Friday to $2.51 million. By comparison, it costs $1.4 million to insure Venezuelan debt and only $112,000 to back Mexican debt.

“The fundamentals have deteriorated so much that we would not expect much investor demand for Argentina paper anytime soon. In an environment of negative EM sentiment, Argentina is amongst the worst of the worst,” Brown Brothers Harriman currency strategists Win Thin and Illan Solot wrote in a note on Thursday.

Argentina, which was one of the best emerging market performers in 2013, has also seen equity prices retreat. The Argentina Merval Index fell 2.2% on Thursday, its worst day since early December, and lost another 2.4% on Friday.

Will Argentina Infect Other Markets?

All of this raises the specter of contagion, which threatens to spread the fears about Argentina to other embattled emerging and even developed markets.

The Dow Industrials suffered a 200-point drop in Friday afternoon trading, on track for their worst day since mid-August.

Closing in the red all five days, the Euro Stoxx 50 Index shed 3.99% this week, its worst since December 2011.

“Equities are in free fall as fears over Argentina’s stability have sent shockwaves throughout global markets,” David Madden, market analyst at IG, told clients in a note.

Block notes that during times of fear asset classes often move in tandem as investors liquidate, even if there is no obvious link between the assets. He cited the selling gold suffered in October 2008 after the fall of Lehman Brothers, despite the fact that the precious metal is supposed to be a safe haven.

So if the emerging market contagion continues, where will it hit next?

After Argentina and Venezuela, Brown Brothers Harriman sees the next weakest links in this space as Turkey and South Africa.

“2014 has an unprecedented amount of political risk in EM. That has already manifested in Turkey, Ukraine and Thailand, but there is still more to come,” the investment bank warned.