Four challenges facing emerging market investors

Exposure to emerging markets for the average retail investor often comes from exchange-traded or mutual funds that invest in a collection of countries. But the performance of broad market funds in 2016 suggests it is time to rethink that approach.

Overall, emerging markets disappointed again this year. The MSCI Emerging Markets Index is heading for its third straight annual decline, down 16 per cent for 2015, as of Dec. 23. It is no surprise, then, that investors have pulled US$500 billion from emerging-market equity funds this year as of the end of November, according to the Institute for International Finance. That figure is one of the biggest flows out of EM stocks in decades.

But a closer look also shows that some of the biggest returns this year were to be found in the emerging world. One of the world’s best-performing stock markets in 2015 is Argentina, which gave investors an annual return of 33.3 per cent (not accounting for currency swings). Other well-performing emerging stock markets include Hungary, Vietnam and Jamaica.

The outliers show the benefits of being selective when it comes to emerging markets. But how do you screen the winners and losers? For 2016, picking the winners will likely hinge on figuring out which countries can overcome the biggest challenges currently facing the emerging world. Here are four of those challenges.

A more hawkish Fed

Emerging markets reacted with surprising calm when the U.S. Federal Reserve raised interest rates on Dec. 16 for the first time in a decade. The test, however, will be how EM assets handle further rate hikes in 2016.

The Fed’s current projections indicate as many as four rate increases next year, which will tighten monetary conditions and potentially lead to an even stronger U.S. dollar.

This will have big implications for those struggling economies where a lot of debt is held in U.S. dollars, including countries such as Turkey, Brazil and Russia. All three of those economies tanked in 2015 as borrowing costs shot up. The latter two countries have fallen into outright recessions.

“Those whose issuing countries have fragile balances of payments, such as the Turkish lira and South Africa rand, may face further losses,” said David Rees, senior markets economist at Capital Economics.

Maturing EM corporate debt

Emerging-market corporate borrowing has exploded in recent years as loose monetary policy in the West led to a borrowing spree.

The International Monetary Fund notes that the corporate debt of non-financial firms across major emerging markets exploded from US$4 trillion in 2004 to more than US$18 trillion as of last year.

A big chunk of that debt is now held in U.S. dollars and is set to begin maturing in the coming years, creating further risk as interest rates move higher.

“According to the Bank for International Settlements, about 40% of the almost $10 trillion stock of dollar-denominated debt held by non-financial entities outside the U.S. is held in emerging markets,” said Krishen Rangasamy, senior economist at National Bank Financial Markets, in a note. “The historic USD surge has now made it harder to service that debt.”

The International Monetary Fund has warned that emerging-market governments need to be prepared for a potential surge in corporate failures, especially as many of the firms that borrowed are resource firms, and may now be struggling to service their more expensive debts amid rock-bottom commodity prices.

Low commodity prices

The commodity price crash has created a divide in the emerging world. It has certainly been painful for large oil exporters such as Nigeria, but countries that are dependent on importing commodities have had huge gains. Countries in East Asia, for example, have received a huge economic boost from the price collapse.

There is some hope that 2015’s heavy selloff could lead to a bounce back next year, but economists caution that slow global growth — the IMF is forecasting growth will rise to 3.6 per cent from 3.1 per cent — will limit any bounce potential.

“We anticipate that the turn of the calendar will not alleviate the pressure that has bedeviled commodity producers and many emerging market economies,” said Marc Chandler, head of global markets strategy Brown Brothers Harriman. “The slow, mostly domestic driven activity of the high income countries, and notably the transition in China, dampens demand growth.”

That means even though some markets such as Qatar, Nigeria and Chile that depend heavily on commodities have sold off this year, they do not necessarily offer investors a bargain.

The threat of ongoing commodity price weakness next year means that those countries will likely continue to suffer a negative terms-of-trade shock, making commodity importers such as countries in East Asia more attractive.

Geopolitical instability

Emerging markets head into the new year with a wave of ongoing conflicts around the world.

In the Middle East, ongoing Western intervention against ISIS militants continues to disrupt oil and gas production in the region. Tensions between Russia and Turkey, two important regional economies, continue to fester following the downing of a Russian fighter jet by the latter in November.

Analysts at Citigroup note that their research shows the market perception of geopolitical risk is at a 25-year high. And that is no surprise. Aside from tensions in the Middle East, there’s the ongoing military escalation in the South China Sea, the growing number of Syrian refugees that could lead to unrest in Europe and the potential for further terrorist attacks around the world.

Emerging-market assets have tended to take the brunt of the blow whenever geopolitical risk flares up. Analysts at JPMorgan Asset Management note that when those selloffs happen, certain emerging-market countries tend to fare worse than others, because their stock markets are more dependent on international investment flows.

They identified the so-called fragile five — Mexico, Colombia, Indonesia, South Africa and Turkey — as being at high risk of big declines in the event of an emerging-market selloff, because they heavily depend on foreign money, which tends to be more skittish. Something to keep in mind for 2016.




Nuria Pujol