Since the Federal Reserve (Fed) first hinted at the possibility of a taper in May, anxiety has roiled emerging markets (EM).
Over the last three months, EM stocks have fallen 12% in dollar terms, underperforming developed markets by 10%, and EM currencies on average have tumbled by 7% versus the dollar. And as numerous market watchers have pointed out, the EM rout has only intensified this week amid concerns about an escalating conflict in Syria and rising oil prices.
It’s no surprise, then, that many investors are asking me when we’re going to see a significant and prolonged reversal in EM stock performance. While I believe that EM stocks, which look undervalued relative to EM markets’ growth potential and healthy corporate profits, have the potential to outperform their developed market counterparts over the next several years, I see few immediate catalysts for a very near-term EM rally, as I wrote in my latest Investment Directions monthly market commentary. That said, investors can watch for four signposts signifying that the EM underperformance tide may be turning.
- More sustainable EM growth, as evident in less volatile gross domestic product (GDP) growth figures and the composition of GDP. For example, China is working to make its growth more sustainable by cutting investment and boosting consumption. Brazil is aiming for the opposite – boosting investment and cutting consumption. The situation in India, as in Brazil, will require a significant investment in infrastructure, as well as a less bloated public sector. Finally, Russia is trying to reduce its dependence on oil revenues and manage its fiscal deficit.
- Inflation that is more under control, as evident in stabilization of countries’ inflation expectations. Brazil and India, in particular, are still struggling with stubbornly high inflation due to supply-side factors and loose monetary policy. This is partly why Brazil’s central bank is busy hiking rates despite the country’s growth challenges. This is also why the market viewed the appointment of famous economics Professor Raghuran Rajan to lead the Royal Bank of India as a game changer that could help restore confidence in India’s macroeconomic management and help buttress the central bank’s credibility in fighting inflation.
- Asset-price bubbles become less bubbly, as evident in China’s “total social financing” indicator becoming more under control. We expect China’s overheated housing market to cool down, assuming the Chinese government succeeds in curbing its shadow banking system, which has been a key culprit behind the country’s rocketing real estate prices.
- EM countries become less reliant on short-term foreign capital funding, as evident in improved current account balances and a shift toward longer-term foreign direct investment. For example, in order to reduce its vulnerability to capital flight, India needs to bring its current account to a more sustainable level. To achieve this, the country needs to make its exporting sector more competitive and increasingly encourage long-term foreign direct investment, reducing its reliance on short-term foreign capital funding.
Most major emerging economies are engaging in various forms of multi-year reform programs in hopes of making their growth less volatile and their financial systems more stable, and I expect to see some of the signposts mentioned above over the next year or two.
In the meantime, the looming phase out of the Fed’s cheap money will likely continue to lead to capital outflow from EM countries and weigh on EM assets. That said, some EM countries are better positioned than others to weather reduced monetary stimulus from the United States. In particular, countries with sound fundamentals characterized by current account surpluses, significant foreign exchange reserves and healthy corporate leverage are likely to better withstand significant capital outflows. Examples of such countries include China, to which I continue to advocate an overweight position.
 “Emerging markets” measured by the MSCI Emerging Markets Index and “developed markets” measured by the MSCI World Index
In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.