Watch for Overseas-Triggered Turmoil

 | Dec 27, 2013 | 10:00 AM EST  | Comments
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EEM

It's the time of the year when pundits offer their recaps of the year that was and offer up their prognosis for the 12 months to come. The consensus forecast for 2014 seems to be gravitating toward a more subdued market ahead: The majority of forecasts are calling for equities to return between 5% and 10% on a slight acceleration of domestic growth.

I think that consensus is entirely reasonable. To a large extent, the political battles of the last few years should be bypassed in the new year due to the approaching midterm elections. U.S. manufacturing activity is picking up, and the housing recovery should continue, albeit at a slower pace. The one big unknown at this point is how our market will behave in the light of the Federal Reserve's stimulus tapering, which it began earlier this week. However, this should be manageable.

The last two major declines in the U.S. market were triggered by domestic events. The "Internet bust" of 2000 caused a major market disruption -- and, in fact, the Nasdaq still has yet to fully recover from it, even 13 years afterward. The housing-and-credit crisis of 2008 almost threw the country into a second Great Depression, and it cut the market's value by more than half.

However, if you recall, in the 1990s a good portion of market turmoil was caused by overseas events -- for instance, the Mexican peso crisis of 1994, the Asian crisis of 1997 and 1998 and the Russian default of 1998. Still, they all triggered significant declines in the U.S. market. If we do witness an unexpected jolt to domestic markets in the coming year, I believe it will come from outside our borders. Here are three plausible overseas "watch-out" items of which to be aware.

Emerging Markets

Major emerging markets, such as those in Russia, Brazil, India and Turkey, are already under duress. These countries are experiencing decelerating economic growth, increasing inflation, political strife and escalating amounts of protests.

I can foresee accelerating pressure on these countries as the U.S. Fed starts to withdraw liquidity from our markets -- and there is precedent for this. In the month following the May 22 congressional testimony Fed chief Ben Bernanke, when he surprised the markets by using the "taper" for the first time, the iShares MSCI Emerging Markets ETF (EEM) dropped 15%.

I could easily see one or more of these countries' economies going into outright contraction if Fed measures have outsized negative impact on foreign direct investment. This would have impact on global economic growth, and it could constitute an unexpected source of turmoil for the markets in 2014.

China

Obviously the biggest emerging market, China, is the most important one. I don't see the Middle Kingdom becoming too affected by the actions of the Fed, and economic growth there seems to have stabilized recently. However, there are still areas of concern to keep an eye on.

New political leadership is now in place in China, along with some new changes in economic policies there that will play out in the coming years. How economic growth responds to these new directives is unknown, and China is in a stellar range of gross domestic product, per capita, that's similar to levels that other centralized economic systems have struggled to maintain.

There is also the matter of trillions of dollars in the "shadow banking" system, as well as massive local government debt that is prevalent throughout the economic system. This is a primary reason that Jim Chanos, a noted China short, has major concerns about the country's trajectory. A major hiccup in China obviously would have severe ramifications for global growth and markets.

Europe

Discord in Europe caused major disruptions to U.S. markets in 2010 and 2011. Concerns about the continent have dissipated since the European Central Bank's Mario Draghi uttered his famous "whatever it takes" comments. However, economic growth is anemic, and unemployment is running at over 12% for the Eurozone as a whole. Focusing on individual countries, Portugal, Spain and Greece are experiencing depression-like levels of joblessness.

Of the major economies in Europe, I would be most worried about Italy. Inflation is lower in that country than it is in the U.S., England or even Germany, bumping along at just above 0%. Deflation for a country with one of the highest debt-to-GDP ratios in the world could be outright disastrous, as falling prices and massive debts are a lethal combination. If Italy needs to restructure its debt, this will cause huge disruptions to the markets.

I do not place a high probability on any of these individual events occurring in the new year. But, if we look at these events as a collective, I do think it is plausible that a one of these global worries will rear its ugly head in 2014 -- so they are certainly worth watching. In short, as investors prudently manage their portfolio in the year ahead, they should be aware of global risks as well as domestic ones.

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