Is it safe to return to emerging market investments?

Is it safe to return to emerging market investments?

Emerging market investments across asset classes have suffered a brutal combination of collapsing commodity prices and a strong US dollar this year. Is the bottom near, and where might investors look for bright spots?

2015 has been a lackluster year for US and European markets, but their performance is still leagues better than what emerging market investors have struggled through. The MSCI Emerging Markets Index is down over 17% year-to-date, and emerging market bonds are down nearly 2% so far in 2015.

Most tellingly, emerging market currencies have been the worst hit, down more than 20% over the last twelve months, which has in part fueled the collapse of other emerging market asset classes. Brazil’s real, for instance, is down 30% year-to-date.

                 Source: Bloomberg and Global Risk Insights

The causes of the destructive trend are not difficult to spot: commodities (led by oil) have fallen to multi-year lows, investors have hit the panic button on Chinese growth, and the US Federal Reserve has signaled an impending rate hike.

As if that tally of obstacles was not enough, two of the major attractions to emerging market investments have been diminished as of late: high growth and low correlation with developed markets. The euphoria-fueled growth rates of emerging markets, especially those of the BRICS countries, are gone. The optimism of investors flooding into these markets for newly-middle class consumers and market-oriented structural reforms may have instead been a thin veneer over high commodity prices piqued by Chinese infrastructure spending.

   Source: Bloomberg and Global Risk Insights

While this growth was seen as a secular trend that could act as a hedge against the cyclicality of developed markets—particularly surrounding the financial crisis—the focus on zero-interest rate policies and quantitative easing by the US Federal Reserve, Bank of England, and European Central Bank have brought investment cycles of developed and emerging markets in line with one another.

2013 and 2014’s taper tantrums are the most memorable examples of this: investors walking back down the risk ladder in anticipation of Fed tightening are moving away from emerging markets as well as developed market equities.

When the sell-off slows, emerging markets will once again be an attractive opportunity

The trends that have led to the emerging market sell-off are not permanent, and when these dark clouds lift, more investors will see promising returns. More importantly, some regions have been unfairly maligned during the sell-off. So is the time right for investors looking to diversify, and if so, where do they turn?

Of course, consistently timing the market’s peaks and troughs is a fool’s errand, but there is one date on the horizon that will keep capital flows in emerging markets in a tenuous place: the Fed’s first rate hike. Once that has passed, especially given the Fed’s guidance that the rate hike cycle will be slow and designed to sustain financial market stability as much as possible, the brighter markets that have been unfairly grouped with less promising markets should begin to shine again.

There are some reasons to believe the future is looking brighter across emerging market regions and asset classes. Currency market observers are beginning to believe that some emerging market currencies are becoming fairly valued again, after being overvalued throughout most of the QE-era. Those that are still unattractive are those with enough dependence on China to spook investors. As momentum falls away from these trades, earnings and yields (in dollar-terms) will stabilize.

Speaking of yields, the transition to local-currency denominated debt in emerging markets has cleared up much of the uncertainty that fueled the 1997 Asian financial crisis: unwise pegs to the US dollar and dollar-denominated debt. Even as investors dump emerging market debt as yields fall due to recent currency movement, the likelihood of default is lower than it historically has been.

“Two dreaded C’s”

The headwinds of China and commodity prices remain a major point of differentiation across regions. Regions with low exposure to those two dreaded C’s will look like fundamentally better investments, at least until uncertainty over those areas persist. If the world is witnessing a secular shift in Chinese growth, that could be a period of several years. The trade linkages of emerging market economies is more important than ever in this context.

Of the several emerging markets that are net commodity importers with low exposure to China, a few are notable: India and Poland. Indian GDP grew 7% last quarter (albeit it partly because of a change in methodology that brings it in line with international norms), placing the country in a unique place with international investors: after Prime Minister Modi failed to live up to the unrealistic expectations for reform that were created during the early days after his election, it lost its place as an emerging market darling.

However, in the current emerging market paradigm, India will continue to benefit from low commodity prices and has an economy that is largely based on domestic goods and services, insulating its business sectors from international uncertainty. While the other namesakes of the BRICS group crumble, each for its own idiosyncratic reason, India looks to be the only one on the upswing.

Poland exhibits similarly low exposure to the dreaded C’s. It sits in a unique trade situation as a major manufacturer for the EU market, especially of automobiles, and an increasingly important member of the EU. Even as Europe has struggled to find growth, Poland has not. Now that the industrial and consumer spending prospects for most of Europe look their best since 2008, Poland stands to benefit. Underlining that potential is Poland’s strong democratic system and its low exposure to China.

While volatility and indiscriminate fear across emerging market asset classes are still high in light of global macro trends, especially the Fed’s rate hike, there is an opportunity to differentiate between markets that will continue to fall victim to these trends, and those that will not. The wholesale euphoria of the last decade’s emerging market investments does not look to be on its way back soon, but the push towards higher growth and market-enhancing reforms still marches on for several key actors.

Categories: Economics, International

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.