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'Fragile Five' currencies threaten Canadian stocks

The Reserve Bank of India surprised markets with a rate increase Tuesday and reports indicate that Turkey's central bank will jack rates higher by as much as 2 per cent at an emergency meeting scheduled for Wednesday.

India and Turkey are unwilling members of what Morgan Stanley dubbed the "Fragile Five" – countries where a toxic combination of slow growth, high inflation and large current-account deficits puts the currencies at risk for a severe downdraft. The remaining members are Brazil, Indonesia and South Africa.

The problems have been growing since May of 2013, when the Federal Reserve signalled a change in monetary policy that caused U.S. interest rates to climb. Alexandre Tombini, Brazil's central bank head, described rising U.S. and developed market interest rates as a "vacuum cleaner" sucking investment funds out of his country.

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Capital flight has been particularly troubling in India. Last June, the Indian government banned the sale of gold coins to prevent citizens from exchanging rupees into bullion. This halted the slide in the currency but only for one month.

India's problem now is inflation. Tuesday's 25-basis-point rate increase in the central bank rate (to 8 per cent) was a direct response to a 10-per-cent increase in consumer prices during December. The weakening currency is making imported goods more expensive and driving consumer prices higher.

In Turkey, political upheaval caused markets to recognize the country's precarious economic situation. In December, Prime Minister Recep Tayyip Erdogan began corruption proceedings against 2,000 supporters of self-exiled Islamist leader Fethullah Gulen.

Fearing political instability, domestic and foreign investors have voted with their feet and moved funds out of the Turkish lira. The currency has declined 11 per cent in the past six weeks.

South Africa is the last Fragile Five country standing – it has not yet been forced to raise rates to protect its currency. A recent labour action by the Association of Mineworkers and Construction Union could provide the catalyst for an investment fund exodus and a subsequent spike in rates.

The South African bond market bears close attention in the coming weeks. If credit markets remain stable, this could signal the bearish trend in emerging market currencies is coming to a close. A big selloff in the rand, on the other hand, would signal further weakness throughout the asset class.

Importantly, the state of developing world debt markets is nowhere near as bad as it was in the "bahtulism" crisis of 1997. Then, the JP Morgan Emerging Markets Bond Index had a yield 16 per cent higher than that of U.S. Treasuries. Currently, the index is yielding 3.8 per cent above U.S. bonds.

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Nonetheless, none of this is good news for Canadian investors. My column this week highlighted the S&P/TSX composite's tendency to closely follow the U.S.-dollar value of emerging markets' assets. Weaker developing world currencies puts downward pressure on the MSCI Emerging Markets Index and, by extension, Canadian equity prices.

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About the Author
Market Strategist

Scott Barlow is The Globe's in-house market strategist. He is a 20-year veteran of Canadian investment banks, including Merrill Lynch Canada, CIBC Wood Gundy and Macquarie Private Wealth (MPW). He was a highly ranked mutual fund analyst for 10 years and then, most recently, the head of a financial adviser support team at MPW. More

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