3 risks that are spooking investors and triggering a global stock sell-off

  • The Dow Jones Industrial Average fell 1175 points, or 4.6 percent Monday.
  • The MSCI Emerging Markets Index fell by nearly 1.75 percent, and Japan's Nikkei 225 dropped by 4.9 percent. The latter has fallen by another 4.73 percent so far today.
  • MSCI EAFE Index, which tracks companies in Europe, Australasia and the Far East, was down 1.7 percent on Monday.
  • Investors fear inflation, tightening by central banks and a strengthening of the U.S. dollar.
A man walks past an electronics stock indicator showing share prices at the Tokyo Stock Exchange (L) and Dow Jones numbers (R) in Tokyo on February 6, 2018.
Behouz Mehri | AFP | Getty Images
A man walks past an electronics stock indicator showing share prices at the Tokyo Stock Exchange (L) and Dow Jones numbers (R) in Tokyo on February 6, 2018.

Friday's stock market sell-off continued into this week, with the S&P 500 falling by about 4.1 percent on Monday and the Dow Jones Industrial Average dropping by 1,175 points, or about 4.6 percent. It's not just American equities that have seen a decline, though — several international indexes have fallen as well. Clearly, international investors are spooked by sudden sharp slides in U.S. equities.

On Monday, according to MSCI, the MSCI Emerging Markets Index fell by nearly 1.75 percent; the MSCI EAFE Index, which tracks companies in Europe, Australasia and the Far East, was down 1.7 percent; while Japan's Nikkei 225 dropped by 4.9 percent. The latter has fallen by another 4.73 percent so far today.

Clearly, the U.S. sell-off is impacting international stocks, but some experts think that more damage could be done to global equities if this rout continues.

"When the U.S. sneezes, the rest of the world catches a cold," says Mona Mahajan, a U.S. investment strategist with New York's Allianz Global Investors. "If the U.S. is selling off, then that nervousness could spread."

While all sorts of things could go awry over the coming weeks and months, there are three risks in particular that could cause global equities to continue falling.

A turn in sentiment

Sentiment, or how people feel about their investments, is one of the biggest risks to market stability. While sentiment has helped push stocks to record highs — the better people feel about the markets the more they'll buy — it could also cause the market to fall further. Why? Because if people feel as if stocks will continue to drop, then they could keep selling, said Mahajan.

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For emerging market stocks, turns in sentiment can be particularly cruel. Investors usually buy into developing nations when they feel comfortable with the market — they're considered riskier assets, even if many of these nations are more stable than they were years ago.

If investors pull out of those risk assets and move into safer securities, like bonds or defense-sector stocks, then emerging markets will take a hit.

That's what happened during the recession. Up until July 2008, the S&P 500 and the MSCI Emerging Market Index moved lockstep with one another. Between July 15, when markets began to fall, and Oct. 28, 2008, when panic began to set in, the MSCI Emerging Market Index fell by 52 percent compared to 22 percent for the S&P 500.

As well, equities in general are much less correlated than they were years ago, which means that a sell-off in America often results in sell-offs elsewhere.

"In risk-off markets all correlations go to one," said Mahajan. "We see a flight to safe assets, and we're already seeing that now with the 10-year bond reversing some of its yield. People are doing a flight-to-safety trade."

Global central bank tightening

One reason U.S. investors are spooked is because some think inflation could rise, which might then force the Federal Reserve to raise rates more than expected. If that happens, then things like mortgages and business-related borrowing could become more expensive and, ultimately, slow down economic growth.

There's some worry that this could become an issue for international markets as well. While places like Europe and Japan still have ultralow interest rates — the ECB's overnight rate is 0 percent, while Japan's is at minus 0.1 percent — their central banks said they want to start raising those rates either this year or next.

"Everything indicates that the ECB will raise rates next year, and it's possible they'll have to move that timetable up," said Mark Zandi, chief economist with Moody's Analytics. "Japan is also feeling more comfortable with its economy and could pick up rates more than anticipated."

In today's economic environment, an increase in rates and inflation is a good thing as it's a sign of stronger economic growth, but if either rise too quickly — and inflation could climb due to higher wage growth and fuller employment — then that could impact consumer spending.

"If everyone's doing well then business could start raising prices more aggressively," he said.

Mahajan is watching emerging market bond rates, where yields can range from 4 percent for Mexican bonds to 7 percent for Indian fixed income.

As of now, yields in emerging market countries are more attractive than American bond yields, she said, but if they start moving higher, then corporate defaults could increase.

As well, emerging market nations are more prone to runaway inflation. It's not an issue yet, but it's something to watch out for, she added.

US dollar climbing

Over the last year, the U.S. dollar has nosedived. The DXY U.S. Dollar Currency Index, an index that measures the value of the greenback relative to a basket of foreign currencies, is down about 10 percent.

While Mahajan thinks the dollar will stay weak over the long-term, in the short-term we could see it bounce back — and that would be bad for foreign stocks.

"A reversal would be detrimental to some of the sentiment and equity markets in emerging markets," she said.

Typically, when the dollar is weak, emerging markets do well as they benefit from cheaper U.S. export prices. Trade imbalances can also be impacted in rising dollar environments.

"Historically, we see an inverse correlation," she said. "A weak dollar means stronger emerging markets, and a strong dollar means a weaker emerging market."

Zandi agreed that a more risk-off environment could bolster the greenback and hurt emerging market stocks, particularly those with larger current account deficits. However, many emerging market currencies have fallen in price — the Mexican peso is down 5.2 percent compared to the U.S. dollar, for instance — so the damage may not be as severe as it could have been.

Still, if U.S. stocks decline further, global equities will continue to fall, too. Zandi doesn't think it's time to panic — "so far it's a garden-variety correction," he said — but Mahajan said stocks could fall for at least another week or two. If global markets drop by 10 percent, start buying in.

"Anything beyond 10 percent is clearly a buying opportunity," she said.

— By Bryan Borzykowski, special to CNBC.com

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