In the robust bull market of 2013, the S&P 500 rose 32.4% while Emerging Markets (EM) as measured by the MSCI EM index fell 2.6%. During January of 2014, we saw another 8.6% drop in the EM index compared to a 3.6% decline in the S&P 500. The pressures in the Emerging Markets that have taken center stage over the past few weeks have spilled over into Developed Markets around the world. Investors have begun to ask whether our slow, prolonged global recovery can be derailed by some ill-chosen policies in a few small countries. Before we give our views on that question, let’s step back and give a little background as to what has led to the situation today.
Since 2009, high levels of liquidity, generated by the easy money policies of many developed countries’ central banks (like the Fed), have flowed into emerging economies. These funds were attracted to the prospect of greater returns from these high growth economies which also boasted much lower-leveraged balance sheets than many of their developed counterparts. The inflow of foreign capital put upward pressure on many emerging market currencies which ultimately has made these countries’ exports less competitive in the global marketplace. Additionally, flush with capital inflows and new wealth, some countries, rather than investing in solid infrastructure-type projects at home, spent unproductively on imported goods. The combination of spending on imports and being less competitive in global markets led many countries to develop growing current account deficits on their sovereign balance sheets.
In May of 2013, Fed Chairman Ben Bernanke telegraphed to the world that we were nearing a tapering of the amount of stimulus that the Fed was pumping into the economy. Equity markets worldwide came under pressure but Emerging Markets, many of which had grown so dependent on foreign financing, plummeted on fears of tightening global liquidity and capital outflows in search of higher yields. When the Fed chose not to taper in September 2013, the EM markets got a short-lived reprieve and rallied. However, taper talk was back in full force in October-November as U.S. economic data showed accelerating growth. Currencies of many EM countries, particularly those with large current account deficits and rising inflation, headed lower as fearful investors pulled capital.
China, as the world’s second largest economy, has significant implications for EM economies. Though it has not played a major role in the very recent EM sell-off, its slowing growth has had repercussions for many Emerging Market economies. China’s rapid growth of past years drove both the commodity super-cycle as well as the economies of many of its SE Asia neighbors who export heavily into China. In the last couple years, China’s growth has slowed to the mid-7% level and will likely remain in a 6-8% range as the government enacts policies that rotate the economy from relying on exports to a more balanced, consumer-based economy. Slower growth in China, which has led to lower commodity prices, has had a ripple effect in commodity-driven EM economies like Indonesia, Russia, large parts of Latin America and South Africa. Heavy exporters to China like Taiwan and South Korea have also felt the effects of their slower growth.
The recent EM panic hit a tipping point during the week of January 20th. Those countries with large current account deficits and inflationary pressures have been particularly hard hit as investors have sought safety. We’ve seen a number of country-specific policy reactions to tumbling currencies and capital outflows.
- Turkey’s Central Bank raised its overnight lending rate dramatically to 12% during an emergency meeting to bolster the Turkish Lira.
- India’s Central Bank unexpectedly raised its repurchase rate by 25bps to 8% to stem inflation.
- Argentina stopped supporting its peso in an effort to preserve it foreign currency reserves. Inflation remains unchecked at almost 30% year-over-year.
- Venezuela, fighting depleting foreign currency reserves and inflation over 50%, devalued its Bolivar.
- The South Africa Reserve Bank unexpectedly raised its key repo rate by 50bps to 5.5% in an effort to support the depreciating Rand and stem the resulting inflation.
Market reaction to the policy moves by central bankers and governments has been mixed at best. We believe investors are questioning these countries’ resolve to take the additional tough steps necessary to fight inflation and rectify certain structural problems given that these steps would likely slow economic growth further. The Emerging Markets have continued to sell off as a group. But it’s important to note that the Emerging Markets are not one homogeneous group. The countries comprising the Emerging Markets are a combination of vulnerable countries and those with much stronger balance of payments, healthy reserves and moderate inflation. However the market has not distinguished much between the fragile and the healthy from either a country or company perspective. We believe this means that there’s an opportunity being created for EM managers who make the distinction and buy great companies as they spiral lower with the broader EM complex.
Are the Emerging Markets nearing a bottom?
We would argue that EM equity prices have discounted much of investors’ fears as evidenced by the 45% cumulative underperformance of the MSCI Emerging Markets Index versus the MSCI World Index over the last three years in dollar terms. However the risk of some sort of EM crisis has risen. Trying to call bottom in the Emerging Markets is like trying to catch a falling knife. An exacerbation of the currency pressures in certain countries or indications that currency issues are spreading could cause painful additional selling in the EM securities. In past Emerging Market crises, EM stocks didn’t bottom until significant current account balance adjustments had occurred. We’re likely some months away from seeing meaningful improvement in vulnerable countries’ current account deficits which leads us to believe that it’s too early to boost EM allocations in portfolios.
Is the current EM situation of a magnitude that can derail our recovery in the U.S.?
We don’t think so. The U.S. economy is heavily driven by domestic consumption and is much less reliant on the rest of the world for its growth. In our 2014 Outlook we made the case for accelerating growth in the U.S. compared to 2013. Our case assumed virtually no pick up in growth in the Emerging Markets. We don’t see the U.S. as totally insulated from Emerging Market issues. If the fragile EM countries get serious about dealing with their structural problems, their interest rates will continue to rise and economic growth would be impacted. This could obviously have some effect on growth here at home, but not enough to overturn the 2.5-3% growth that we anticipate in 2014.