The worst thing about investing in emerging markets is the headlines. News that Argentina bumped interest rates to 60 per cent on Thursday to stop a free fall in the peso, coupled with the sickening descent of the Turkish lira in recent weeks, is enough to make even hardened investors question the wisdom of venturing outside the cozy confines of North America.
But if you believe in the fundamental appeal of emerging markets, this isn’t the time to panic.
For starters, Argentina and Turkey have little effect on the widely used MSCI Emerging Markets Index, a barometer of stock market performance in 24 developing countries.
Turkey constitutes about half of one per cent of the benchmark. Argentina is not even part of the MSCI index – after years of being excluded from the grouping, it won readmission to this summer, but the reclassification doesn’t take effect until next May. However you slice it, what happens in either country is going to have next to no effect on your investing results.
So why have emerging markets suddenly become dirty words? The most credible reasons stem from anxiety over possible trade wars and the effect of rising U.S. interest rates on loans emerging markets investors have taken out in U.S. dollars. A pricier greenback makes those debts harder to service for foreign borrowers. In a worst case, this could lead to a downward spiral, marked by growing defaults and falling emerging market currencies – a contagious crisis reminiscent of the Asian catastrophe of the late 1990s.
“It’s become at least possible to envision a classic 1997-98-style self-reinforcing crisis: Emerging market currency falls, causing corporate debt to blow up, causing stress on the economy, causing further fall in the currency,” Nobel Prize-winning economist Paul Krugman noted in a tweet in May.
While it’s possible to envision a crisis, there are compelling reasons to doubt it will occur. Research Affiliates LLC, a markets analysis firm based in Newport Beach, Calif., argued in a June report that weakness in emerging markets stocks makes for an excellent buying opportunity.
Emerging countries have become substantially wealthier since the Asian crisis, Research Affiliates noted. Since 2000, China’s real gross domestic product per capita has grown by 60 per cent, India’s by 41 per cent and South Korea’s by 24 per cent. All things being equal, a rising level of affluence makes them that much more resilient to crisis.
Furthermore, the big problems in emerging markets appear confined to countries that make up only a small portion of the index. Turkey and Argentina are both unusual cases that suffer from specific issues – spectacularly inept monetary policy in Turkey, and a legacy of mismanagement, high inflation and foreign-currency borrowing in Argentina.
In contrast, the states that make up the bulk of the emerging markets index – China, South Korea, Taiwan, India and Russia – have only modest levels of external debt in comparison to their economies and ample foreign-currency reserves. Most run current account surpluses, meaning they sell more to the rest of the world than they consume.
It’s easy to point to challenges around each of these economies – that’s why they’re labelled emerging, after all – but the issues appear to be amply reflected in the cheapness of their stocks. While Canadian and U.S. stocks are typically trading for 18 to 21 times earnings, the stocks in the MSCI Emerging Markets Index change hands for less than 13 times. Using a wide range of valuation techniques, Research Affiliates concludes that the highly priced U.S. market actually looks substantially riskier than modestly valued emerging market equities.
To be sure, valuation is in the eye of the beholder. While the problems in Turkey and Argentina seem very unlikely to spark a wider panic like the late 1990s Asian disaster, it is quite possible that emerging markets as a group could lag behind for a while.
The folks at Capital Economics in London argue that the real issues facing emerging markets are a slowing Chinese economy and worries about a Sino-U.S. trade war. On top of that, many central banks in emerging-market countries are raising interest rates, a move that may help stop capital flowing out of their economies, but is also likely to slow growth.
“The risk of contagion” from Turkey to other emerging markets “is probably quite low,” Capital Economics noted in a report. “This does not mean that a sustained rebound is on the cards, though.” It argues that the real pressure on emerging markets will come next year, when it expects the U.S. economy to slow sharply, dragging down asset prices across the emerging world.
Of course, this raises the question of whether an investor would prefer to be in a decelerating North American economy or in emerging markets. Ben Inker of money manager GMO LLC in Boston argued in a recent report that value stocks in emerging markets “represent the most attractive asset we can find by a large margin” because of their bargain valuations.
“Our models do not take into account the potential effects of a trade war, but while a trade war is presumably a negative for emerging assets, it should arguably be at least as negative for U.S. assets,” he wrote. Investors who are scurrying from emerging markets and looking for a haven in North America may want to ponder that.