Investors continue to abandon emerging markets. As I write in my new weekly commentary, last week marked the 14th week of outflow from emerging market equity funds and the largest weekly outflow seen since August 2010.
Last week’s selloff came as number of emerging market countries – including Turkey – raised their benchmark interest rates in an effort to stem the pressure on their currencies, and as political turmoil in the Ukraine and Thailand continued. As we’re coming off a long period of market complacency that sent risk assets to relatively high levels, these local emerging market headlines are starting to have an effect amid relatively fragile market sentiment and a generalized flight to quality.
However, regardless of what sparked the latest selloff, the correction we are seeing, like the ones we saw in May and June, is a good reminder of these three truths about emerging market investing.
Truth: Volatility in these markets can’t be avoided. Emerging markets tend to be volatile, and they’re likely to remain so, at least in the near term. As emerging market currencies remain under pressure, the Federal Reserve tapers and several countries struggle with lingering structural issues, emerging market volatility is likely to remain high in the coming months.
Truth: Not all emerging markets are created equal. In other words, the issues facing countries like Turkey and Indonesia are not the same ones facing other emerging markets. Despite the dour emerging market headlines, some emerging markets, particularly in Northern Asia, appear more resilient. For example, both China and South Korea are running current account surpluses and both have large foreign exchange reserves.
Meanwhile, though I still advocate some caution toward Mexican stocks, Mexico’s fortune is tied to the improving U.S. economy, and the country has recently witnessed a number of key structural reforms. In addition, Fed tapering is likely to impact emerging markets differently given the markets’ differing fundamentals. Countries dependent on foreign funding, such as Turkey and South Africa, are likely to struggle disproportionately. In contrast, countries such as China and Korea are likely to be more resilient to U.S. tightening fears.
Truth: Emerging markets offer deep value. Given that they’re generally growing faster than their developed world counterparts, emerging markets still look cheap by most metrics. Currently, emerging market equities are trading at about a 40% discount to developed country stocks. This represents the largest discount since the financial crisis.
So what do these truths means for investors? Over the long term, the movement that we have seen in currencies, interest rates and emerging market equities is actually a good thing as it facilitates a much-needed macroeconomic adjustment. Recent events also remind investors that it’s impossible to time the markets. That said, I still view emerging markets as a strategic asset class and wouldn’t abandon them.
Finally, given that not all emerging markets look equally attractive, I continue to advocate taking a more discerning approach to this asset class. I also am a proponent of expanding the definition of emerging markets to include frontier markets, which are up roughly 18% since last year.
The bottom line: If you want exposure to the economic growth and financial deepening in these markets, consider allocations over the medium and long term, selectively finding value and waiting out the storm.
Source: BlackRock, Bloomberg