A stock board in Brazil. (Photo: AP)
Emerging markets equities have experienced double-digit declines this year, a painful reversal of fortune after gaining more than 30% in 2017. Investor sentiment toward emerging markets turned negative for a variety of reasons. U.S. dollar strength, tightening global liquidity and the slowdown in Chinese growth are among the headwinds for emerging economies. Trade tensions between the U.S. and China also aren't helping investor sentiment. Despite the near-term risks, emerging markets equities offer attractive long-term growth prospects and increasingly compelling valuations. Investors should understand the near-term risks, while recognizing the long-term opportunities.
Contagion Risk
Historically, the combination of Fed tightening cycles and a strong dollar has been toxic for emerging markets equities. Mexico's peso devaluation in 1994 was the catalyst for a wave of currency devaluations in Latin America. The economic contagion stemming from Mexico's crisis became known as the "tequila effect." Asia had its own crisis in 1997, creating widespread instability and fears of a worldwide financial crisis. Currency challenges in Turkey and Argentina fuel speculation that another wave of contagion will hit emerging markets.
Fear of contagion may be misplaced, given the substantial differences between emerging markets economies in the 1990s and today. In the 1990s, many emerging market countries had significant current account deficits and an abundance of short-term, U.S. dollar-denominated debt. Many were vulnerable to a surge in the U.S. dollar and were overly reliant on foreign capital flows.
Today, emerging market countries are far more resilient. For example, Thailand was at the center of the Asia crisis in 1997. Today, Thailand has a current account surplus and minimal external debt. According to Alpine Macro, countries with current account surpluses represent nearly 70% of the market capitalization of emerging markets equities, up from 15% in the 1990s. Many of these countries have little in the way of foreign currency debt.
Slowing Demand for Commodities
Commodity-oriented companies once dominated emerging markets equity indexes. Massive spending by an industrializing China created a commodity boom that boosted growth for many commodity suppliers. As China moves to a more mature economic growth model, investors fear the implications of slowing demand for commodities. Commodity producers will undoubtedly struggle as China's pace of urbanization slows. However, it is an outdated premise to assume that emerging markets equities rise and fall based on commodity demand. Commodities now only represent about one-quarter of emerging markets index market capitalization, down from more than half of market capitalization in the 1990s.
Trade Tensions and Slowing Chinese Economic Growth
Chinese equities are among the worst performers in the world this year, and the fall in the market has erased nearly $3 trillion of market value. However, the Chinese stock market isn't a reliable guide to the health of the Chinese economy, given the degree to which the local market is dominated by short-term traders.
