A perspective from E*TRADE Securities2
Last month we discussed the inconsistent performance of emerging markets, which recovered from a dismal stretch spanning 2013 to 2015 by posting double-digit returns in 2016 and 2017 before losing steam in the second quarter of this year. Year-to-date, emerging markets are off by more than 7% and have taken a hit over the past month amid negative headlines out of Turkey.1
A fistful of dollars is dealing a bad hand to emerging markets
The poor performance of emerging markets in 2018 is evident in sovereign international currencies, most of which have depreciated versus the dollar. In fact, among major emerging market currencies, only the Mexican peso has risen against the dollar year-to-date.
This matters, because the performance of emerging market stocks has historically been inversely correlated to the US dollar. In the chart below, notice how emerging market stock performance has improved when the dollar has weakened, and vice versa.
Source: FactSet Research Systems, August 15, 2018
What does the US dollar have to do with emerging markets?
The US dollar helps drive emerging market performance in part because commodities—think crude oil, natural gas, metals, livestock, and grains—are largely denominated in dollars, and commodities are major exports in the developing world. When the dollar strengthens, commodities become more expensive in dollar terms, which can depress demand.
One reason for the US dollar’s recent strength has been rising Treasury yields, which have attracted yield-hungry international investors and driven up demand for the greenback. As the Federal Reserve unwinds its balance sheet by selling off Treasuries and asset-backed securities, rising Treasury yields and a strengthening dollar could continue to pressure emerging market shares.
What’s the story with Turkey?
The major international event since July involves Turkey—the world’s 17th-largest economy and a cultural bridge between the Middle East and the Western world. Since the 2014 election of President Recep Tayyip Erdoğan, Turkey has been running large current account deficits fueled by large-scale infrastructure spending and funded by international borrowing.
As confidence in Turkey’s ability to service its debt has eroded, the Turkish lira has sold off, losing roughly 40% of its value since the start of the year. One initial concern was that that the country’s financial crisis could affect European banks, some of which have significant exposure to Turkey.
Source: FactSet Research Systems, August 15, 2018
Although there are many differences between emerging market regions…
The extent to which Turkey’s travails have roiled financial markets in both the developing and developed world speaks to the interdependence of nations in the global economy. But should investors who are bullish on Latin America pay the price for a crisis in Ankara? After all, there are meaningful differences between emerging markets and many success stories to be told.
In Mexico, the strengthening peso reflects confidence in the country’s growth prospects and a favorable reaction to newly elected President Andrés Manuel López Obrador’s pledge to maintain central bank independence and contain domestic spending, with the possibility of renegotiating the North American Free Trade Agreement as well.
In East Asia, the so-called “Asian Tigers” of Taiwan, Singapore, South Korea, and Hong Kong continue to grow their export-dependent economies at a steady pace, while Indian equities are on a remarkable tear of late. In fact, Asian countries comprise four of the five largest weightings in the MSCI Emerging Markets Index—a major barometer of emerging market performance.
Source: MSCI, Inc., July 31, 2018
…investors tend to lump emerging markets together
Despite these differences, however, emerging markets are known for economic and market contagion, a variant of “one bad apple spoils the whole bunch.” For any number of reasons, one or two localized crises can topple emerging market shares across the board.
A case in point: The MSCI Emerging Markets Index fell to its lowest level in a year on August 12, amid the deepening financial crisis in Turkey, despite the fact that Turkey makes up only a small portion of the index.1 To be sure, Turkey has unsettled markets in developed economies as well, but emerging market stocks bore the brunt of the damage.
Don’t let the fear factor dictate your decisions
So what can investors with international exposure take away from recent volatility?
• We’ve said it before: Investors who have faith in emerging markets shouldn’t let fear dampen it. As the name suggests, most of the world’s growth is poised to happen in emerging markets over the next several decades.
• Downturns can make good entry points, and emerging market valuations remain compelling. Those who fled emerging markets in 2016 after a shaky couple of years missed out on impressive gains over the ensuing two years.
• Investors can allocate assets according to their own expectations. While emerging market ETFs that track broad-based indexes have advantages in terms of transparency and diversification, the downside is market contagion that can affect the entire fund. Investors who are bullish on one region can rebalance their international allocation to favor that region.
Keep in mind that investing in emerging markets is inherently risky and returns can be lumpy. Emerging markets are never going to be a smooth ride, but given their growth prospects, there are many potential rewards.