What Happened to Emerging Markets?

Emerging markets has had a tough year. Since Late January 2018, emerging market equities have shed over 20% in value and are likely the biggest red number in your portfolio. During the nearly two-year period from March 2016 to the end of January 2018, emerging markets returned over 75%. What happened?

There are a number of factors that have driven this pull back, but chief among them are a strong US dollar and increasing trade tensions.

Strong dollar

In general, a stronger dollar presents challenges for emerging market economies which stem from a number of issues. The first major issue is increased cost of servicing their dollar denominated debt. For a myriad of reasons, emerging market economies often borrow using instruments that are denominated in major currencies such as the US dollar as opposed to their own local currency. As the dollar strengthens relative to the local currency, the cost of paying off their debt in dollars rises, causing a drag on economic activity.

A second challenge is capital flight. Oftentimes a strong dollar is associated with a strong US economy and rising interest rates. This creates an attractive opportunity for investors, and investors often reallocate their capital to the US in these circumstances. This generates challenges for emerging markets, who are often in need of more investment than their native capital can support.

Trade tensions

A further drag on emerging markets has been ongoing trade tensions since March of this year. Emerging markets, as net exporters, are especially vulnerable to tariffs and other trade restrictions. For example, exports of goods represent 19% of China’s GDP according to the IMF, whereas in the US, exports only make up 8% of GDP. And China is not the only emerging market dependent on exports. In Taiwan, an incredible 53% of their GDP is comprised of exports according to the IMF. As a result, impediments to free trade have an outsized impact on emerging markets.

The Future

Despite the challenges facing emerging markets from trade tensions and a strong dollar, emerging markets still represent a good investment opportunity. Long-term economic forecasts show the emerging markets have the most growth potential, and while 2018 has been a bumpy ride, the future looks promising. Indeed, the underlying economic trends in most emerging markets are positive (Turkey and Venezuela currently stick out as exceptions to these positive underlying fundamentals). Emerging markets equities are now trading below their historical average valuations, suggesting that strong returns going forward are possible.

Conclusion

Emerging markets have faced a tough economic climate in 2018, after several years of outstanding performance. While it’s been a tough year in 2018, if you had been invested in emerging markets for the three years ending on September 30, 2018, you would have received an annualized 12.38% return over those 3 years, or over 2% higher than the historical average S&P 500 return.  Emerging markets are doing just what emerging markets do.  We expect them to carry extra risk, which is also why over the longer term they can carry extra return.