Emerging markets are headed for trouble

Emerging markets are headed for trouble
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In this debate series, GRI asked: With increasing political risks and instability occurring in spots such as Turkey and Brazil, is there still an appetite for investors to invest heavily in these emerging markets? Analyst Eric Simmons says to hold off for now. Read the opposing case here.

The past few years have shown an influx of investors into the emerging markets asset class, but this appetite will soon taper off and heavy investment in this area will not be sustained. As political risks continue to increase in emerging markets countries, we will see a decrease in both the number of supportive monetary policies undertaken by the G20 economies as well as the overall level of geopolitical uncertainty that currently exists in the developed world. The resulting impact of these forces will be the elimination of the financial environment that has been extremely conducive to emerging market investing.

Although emerging market countries such as Turkey, Brazil, and Thailand are dealing with their own increases in political risk, Wall Street has tended toward investment in their emerging market economies as it waits for the developed world to settle down, at which point it will rebalance its portfolios back in the developed direction. As we move into the end of 2016, emerging markets will continue to have to navigate through increasing geopolitical headwinds while the developed world’s risks moderate, effectively tipping the risk/reward balance for investors back toward the developed markets.

The current positive trend for EMs 

In recent years, dovish monetary policies (e.g., keeping interest rates at all-time lows, engaging in quantitative easing) have taken root in a number of developed economies, supporting an increased level of risk tolerance by investors and effectively overcoming what has been a historical barrier to entry for the emerging markets.

In almost all corners of the globe, from the Bank of Japan to the Bank of England, the ECB to the Fed, yield has been wiped off the table in the developed world’s markets, fueling a rally in emerging markets investing where returns can be significantly higher.

Key to the increased appetite for emerging markets investing is the unrelenting nature of these accommodative policies, as investors view the expansionary efforts of the world’s foremost central banks as here to stay. Attracting monikers such as “QE infinity,” the monetary policies of the developed world have essentially forced investors to look elsewhere for returns.

Additionally, the policies of the developed world’s central banks have put downward pressure on the United States Dollar (USD), which has supported the commodities prices and, in response, emerging markets too. Generally, commodity prices move inversely to the USD because global commodities prices are quoted in USD. Therefore, as the USD falls, commodity prices trend higher.

Notably, resource-driven emerging market countries such as China, Russia, Turkey, Brazil, Qatar, and the UAE have specifically benefited from price support after a tumultuous economic decline in recent years, adding further to global investor’s interest in emerging markets.

Why the trend won’t hold

It is true that in conventional times, the uptick in emerging markets investing might hold. With the fiscal and monetary policies of the world’s leading countries based on economic fundamentals, the aggregate impact of these policies would be demonstrated by continued investment growth in areas outside the developed world.

However, today’s state of international affairs is anything but conventional, and instead encourages central banks to fearfully consider financial contagion when crafting policy rather than focus on pure market fundamentals.

For example, in the second half of 2015, the United States raised key interested rates and considered winding down its own accommodative monetary policy amid positive economic reports. As we moved into 2016, though, the Fed’s maneuverability was hamstrung by increased political risk in the developed world — namely the UK’s referendum on the European Union and the rise of a nationalist candidate in the US election — forcibly preserving the status quo, shelving any further rate hikes, and, in effect, supporting emerging markets investing.

Spanning the globe, many other political risks have emerged this year: a recent coup attempt in Turkey, an impeachment proceeding in Brazil, an ongoing refugee crisis in Syria, and last month’s bombings in Thailand. Given this geopolitical backdrop, it is not hard to understand central banks’ reluctance to change course as the interconnectivity of the global market place begets caution.

As these political risks continue to plague both the developed and emerging worlds, investor appetite will be predicated upon trend lines.

On the one hand, the developed world’s risks are seemingly in decline as the unconventional candidate loses ground in the US and the unprecedented referendum is dealt with in the UK. Meanwhile, the emerging world’s risks remain, as Turkey and Thailand continue to move further away from democratic principles, Brazil continues to superficially deal with systemic corruption, and Russia continues to align itself with NATO adversaries, all of which presents a picture of increasing uncertainty and risk for the emerging markets in the second half of 2016.

On balance, the trends of the political risks associated with the developed and emerging markets suggest that a return to historical norms will soon take form, with investors shifting back to the less risky assets of developed markets.

The tipping point is near, as demonstrated by the market movement which occurs at the mere suggestion of tightening by the developed world’s central banks, as seen recently with the hawkish commentary by New York Fed President William Dudley. All of this underscores the delicate balance of the developed/emerging market asset allocation and its susceptibility to shift in the second half of 2016.

Expect to see increased risks

Brazil is different than Turkey, which is different than China, which is different than Russia. And although a number of investors gain exposure to the emerging markets through broad-based and diversified investment vehicles, many professionally managed funds have the wherewithal to focus on specific countries — a trend that may continue to grow in popularity and which muddies our ability to measure investor interest in emerging markets as a whole.

As political upheaval in Turkey forces investment flows out of the country, for example, more stable GDP figures from China could offset those draw downs, which would make it difficult to discern overall market sentiment toward emerging markets.

Regardless, on a macro level, the risks associated with emerging market investing will continue to increase in 2016 while those associated with the developed market will continue to decrease. As a result, monetary policy will begin to separate itself from the binds of political risk that have constrained it in early 2016, leading to a tightening which will soon reverberate through the developed world and call investors home from their summer vacations.

GRI Debates provide critical insight into the world’s most challenging political risk topics. Through well-balanced opinion based articles, GRI Debates offer a forum for deeper discussion into how major political decisions and security challenges affect markets, investment, and economic growth across the globe.

About Author

Eric Simmons

Eric Simmons is a strategist at a leading multinational financial services corporation in New York. He received his BA in Economics & Government from Colby College, prior to his current role he has worked in Economic Consulting in Washington D.C., and at the United States Senate. All views expressed are solely those of Eric and do not represent the views or opinions of his employer.