Emerging market woes offer unsettling reminder of 1998 crisis

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It's one thing to expect emerging market stocks to be volatile. It's another thing to see them threatening the rest of your portfolio.

Russia's sliding ruble and the central bank's extraordinary efforts to halt the currency deterioration are drawing comparisons to some of the darker periods of emerging market turmoil – and they are also raising concerns about a potential spillover to the rest of the world.

In other words, welcome to 1998.

The year marked a particularly unsettling time for investors, when Russia defaulted on its domestic debt just a year after the Asian financial crisis sucked money out of countries such as Thailand and South Korea and pushed many economies into recession.

The pain moved well beyond emerging markets. Long-Term Capital Management, a highly leveraged hedge fund, failed and the Federal Reserve had to step in with a massive bailout package to head off a financial chain reaction.

Reflecting the broader fears, the S&P 500 fell more than 19 per cent between July and the end of August. Canada's S&P/TSX composite index fell more than 30 per cent between April and October.

Should investors brace themselves for another spillover?

So far, the worst damage has been limited to Russia. The ruble fell to record-low levels against the U.S. dollar even as Russia's central bank raised its key interest rate to 17 per cent.

The iShares MSCI Russia Capped exchange-traded fund fell as much as 9 per cent on Tuesday, before rebounding – and that followed an 11.4-per-cent dip on Monday.

More broadly, emerging market stocks took a similar route, falling toward their lows for the year in early trading before rebounding.

Investors rushed for safety, driving down yields on the world's rock-solid bonds. The yield on the 10-year U.S. Treasury bond sank to a new 2014 low, below 2.07 per cent. The yield on Germany's 10-year bond fell to 0.594 per cent, also a new low for the year and down from nearly 2 per cent a year ago.

But the bigger issue is what impact Russia can have on developed market stocks if the crisis moves abroad.

David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates, noted some eerie parallels between the late 1990s and today: Then and now, Japan was in recession, Europe was in disarray (ahead of the currency union), oil prices were collapsing and the Federal Reserve was bent on rate hikes following a long bull market and economic expansion.

But he pointed out that the S&P 500 actually did just fine during the 1990s crisis, if you held on through the various bumps. From start to finish, despite a spike in volatility, stocks during the crisis rallied more than 40 per cent.

"Can the U.S. economy continue to expand – and the bull market in equities remain intact – with the rest of the world in a mess?" Mr. Rosenberg said in a note. "The answer is yes."

Michael Hartnett, chief investment strategist at Bank of America, said that a crisis can send money flowing toward sectors with the most certain outlook for growth. Today, those sectors are U.S. technology and health-care stocks.

On Tuesday, developed market equities swung wildly. European stocks rallied more than 2 per cent. But the S&P 500 fell 16.89 points or 0.9 per cent after surrendering a 25-point gain earlier in the day.

The S&P/TSX composite index ended the day up 156.4 points or 1.1 per cent on a sudden urge among investors to buy beaten-up energy stocks – but the index had been up as much as 350 points earlier.

The lesson: You can count on plenty of thrills and chills if 1998 offers investors a template.

According to Mr. Rosenberg, market activity during that period was "so treacherous that it seemed like we were always on the verge of a new bear market or recession over in this part of the world."

Just as important, emerging markets no longer kept their volatile ways to themselves.