Stock markets around the world have shuddered as emerging markets have struggled out of the gates in 2014, with the benchmark stock index down more than 7% during January.1 The outlooks for countries from China to Chile have fallen sharply as a number of emerging-market currencies have weakened against the dollar. One culprit for the current flare-up: the slowdown in the Fed’s stimulus programs.
If rates move higher and currencies devalue relative to the dollar, it may hurt countries that rely on export demand to drive economic activity or that rely on foreign funding. That could spell trouble for emerging markets relative to developed markets over the short term.
“We have just come through a period when emerging-market consumption and wealth were rising above trend for artificial reasons,” says Sammy Simnegar, portfolio manager of the Fidelity® Emerging Markets Fund (FEMKX). “This is now going to correct, and we’re probably going to be below trend for some time before we normalize.”
How rising rates are challenging emerging-market growth
Over recent years, emerging markets benefited from falling U.S. interest rates that helped drive investors to put money to work in emerging markets in search of higher returns. The easy access to capital led some countries to borrow heavily, and the relative strength of emerging-market currencies encouraged more consumer borrowing, consumption, and economic growth. Now, with the U.S. economy accelerating, the Federal Reserve has begun to reduce its stimulus, and the market sent interest rates up significantly last year. This has caused all those tailwinds that supported emerging markets to reverse. Capital is flowing out of emerging-market countries, currencies have weakened, and in many countries domestic consumption and economic growth seem to face headwinds.
“I think of emerging markets as high beta bets on long-term interest rates in the United States,” says Simnegar. “You had high beta spread contraction as the United States went through falling rates and disinflation, and if long rates back up, which looks likely, you’re going to have higher beta spread expansion, which will expose investors to more volatility and risk.”
These issues have the biggest potential to affect the countries that depend the most on foreign capital. This means countries that rely more on domestic consumption and less on debt may be less affected, while countries that rely more on exports and have a greater dependence on dollar-based lending could suffer more.
“Countries such as the Philippines and India are very oriented to domestic demand and thus have less exposure to dollar-based lending and less reliance on foreign capital compared with countries like Turkey, which have relied on foreign capital to fund current account deficits.”
Simnegar says that finding countries insulated from some of these issues has been a key part of his investing strategy. He has also been looking for countries willing to make structural reforms, and trying to limit exposure to China. He uses Brazil and Mexico as an example. Over the last decade, in Brazil, you had commodity prices up, interest rates came down from 20% to 10%, and the currency strengthened from an exchange rate of 3.5 Brazilian reals per U.S. dollar to 1.5. That led to an annual 8% wage growth, while productivity per worker actually shrank by about 1% per year. So Brazil saw a lot of wealth creation but not a lot of meaningful reform. Meanwhile, Mexico passed energy reform, which means they will have massive investment in energy and infrastructure, which could help their economy to grow. Mexico is also very geared to a U.S. recovery, where Brazil is geared to China, where a slowdown seems more likely.
The time to buy may not have arrived yet
Despite the recent sell-off, Simnegar thinks there may still be more pain ahead before things get better. He says it will take several quarters for the events happening today to manifest themselves in earnings and economic growth.
“Countries like Brazil and Russia were producing 1% to 2% real GDP growth with 5% to 7% inflation, so with currencies blowing out and higher rates, I think they will have a hard time growing,” says Simnegar. “As an international investor, would I rather own in the United States, with 2% to 3% growth, the rule of law, and low inflation, or emerging markets, where I could have flat growth, 6% inflation, and currency volatility?”
Furthermore, today’s valuations have not yet reached an attractive entry point. Simnegar says that despite an overall P/E for the index at around 9 or 10 times earnings, the median is much higher—closer to 15 times earnings.2
“The disparity is because the mega-cap names that are heavyweights in the index are trading at single digits, but the smaller mid-cap names are trading at much higher multiples than in the United States,” says Simnegar. “So, I think it’s harder to find value in good companies in emerging markets—I just don’t think we are there yet.”
At the same time, there is no reason to think the current volatility will turn into a repeat of the crises that drove emerging-market valuations much lower during the 1990s. For one thing, many oil-producing countries suffered when prices in the 1990s reached $10 per barrel, far below today’s levels near $100. At the same time, many countries had pegged their currencies to the dollar, while today you have more flexible exchange rates.
“The currency structure is more sustainable, commodity prices are higher, and there is much less debt in the system,” says Simnegar, “So, I don’t see a repeat of the crises of the 1990s playing out on a mass scale.”
The long term
The relative strengthening of the United States and other developed economies is definitely creating headwinds for emerging markets. But over the long term, the rising consumer wealth, positive demographics, and untapped economic potential that helped stocks in these markets to run during the last decade are all still intact. But it may take a few years for these countries to work through the impact of a stronger dollar, and to make their economies more competitive.
“Are emerging-market consumers going to be wealthier and better off in five to ten years?” asks Simnegar. “Do I think that they’re probably going to get poorer before they get richer? My answer is yes to both.”
How will you know when the time for emerging-market resurgence has come? Simnegar points to two signs that things might get better. First is the end of the Fed taper. The reductions in liquidity created by the taper will pose a headwind, but the Fed may complete that process later this year. Second are bond yields; Simnegar says to watch for stabilization in the 10-year Treasury and in the spreads between emerging-market debt and U.S. debt.
“What I hope happens,” says Simnegar, “is that countries take this opportunity to pass some tough reform measures, so that their economies come out of this more competitive and resilient.”
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