Emerging markets are crashing – what does it mean for your money?

Emerging market stocks are taking a pounding and their currencies are plunging. John Stepek explains why, and what it means for you.

It's all kicking off in emerging markets.

They've been having a tough time amid fears of a China slowdown and the US scrapping quantitative easing (QE).

Investor favourites such as Thailand, the Philippines and Indonesia took a pounding yesterday. Brazilian shares are now in bear market territory.

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Meanwhile, their currencies are plunging the Indian rupee is at a record low against the US dollar, and the South African rand is at levels not seen in four years.

So what's going on? And will it spread further?

Pay attention to your gut

The most idiotic and damaging idea that ever caught on in finance is the notion that investing is a rational process.

It involves people. How can it be rational?

So in among all the number-crunching and data-watching, I've found that it pays to listen to your gut as well.

I'm going to share one of my personal early warning' signs with you. When people in the City start talking up investment prospects for Africa, I get a horrible sinking feeling in my gut. It usually means the bullish times are drawing to an end.

Now, I find Africa exciting as an investment idea. It also seems to me that the economic situation in many parts of Africa is generally improving. So this isn't a comment on prospects for the continent at all.

But of all the frontier', high-risk markets out there, Africa is pretty much still number one. So when the City starts trying to punt Africa to private investors, it suggests that risk appetite is approaching extremes. People are only thinking of potential gains, without considering potential losses or past disasters.

This is just a general feeling, of course, based on a non-scientific view of the sorts of press releases I get sent, and chatter from fund managers.

But a more concrete example of this sort of exuberance was the government of Rwanda's recent achievement in borrowing money for 10 years from investors at less than 7% interest.

The rout in emerging markets could continue

My point is that regardless of their individual merits the basic problem for emerging markets is that they still depend a great deal on global risk appetite.

With the Federal Reserve apparently underwriting all risk-taking with a guarantee of printed money, investors got very excited about snapping up all these great emerging market stories.

With Europe looking un-investable for many people, the likes of Indonesia and Thailand, with their young populations and growing middle classes, look like great opportunities.

And they were. Trouble is, investing isn't all about good stories. It's about good prices. A market can be the ugliest-looking on the planet but if the bad news is priced in, you can make a fortune by buying it. Alternatively, a market can have the most wonderful outlook but if it's priced in, you can go bankrupt backing that story.

Many of the most attractive markets have grown very expensive. Now that the Fed is threatening to pull the plug on quantitative easing and the Japanese show no desire to plunge into the market at every wobble risk appetite is receding.

When risk appetite recedes, it's a little like investors are waking up from a wild bender. In the cold light of day, the decisions they made whilst intoxicated by the promise of massive gains the night before don't look so clever. "I lent how much? To who? Please tell me you're winding me up."

So they pull out of the riskiest and most expensive stuff first. Prices fall, and as a result, the sell-off spreads. And if prices were very high to begin with, they can fall very far, because it's a long way before they get back into bargain' territory.

How long will the sell-off go on for?

Well, the other big problem here is liquidity. Emerging market stocks are often harder to buy and sell than developed world ones. So if you're going to panic, it's best to panic first before everyone tries to get out of the door. That makes these sorts of sell-offs rather self-sustaining.

But what this really boils down to is a fit of QE-withdrawal nerves. Markets first started getting it into their heads that the Fed was going to pull out of QE around March. You started to see wobbles in higher-risk assets at that point.

However, the Bank of Japan then stepped in and decided to print loads of money. That perked investors up a lot, seeing that someone had taken up the baton from the Fed.

But with the rocket and then slide in the Japanese market, investors have rapidly lost faith in the Bank of Japan's ability to prop markets up as skilfully as the Fed.

In the absence of printed money, everyone is starting to wonder whether the fundamentals justify where asset prices are now. One thing's for sure, though. If US government bond yields don't stay as low as they are now, there's no way that the yield on emerging market debt should be as low as it is.

What does this mean for you?

Money being sucked out of emerging markets and brought back to the US will only continue to boost the dollar. But in turn, that might force the Fed to back-pedal on its plans to rein in QE.

However, don't expect that to happen immediately. The Fed really needs more of an excuse a bigger crash basically before it can start being more investor-friendly again. I suspect markets are now facing a tougher ride in the months ahead. There's also the risk that the Fed simply loses control.

Given that, I'd still be holding a bit of gold as insurance. I'm happy to keep drip-feeding money into Japan for the long run, and Italy too although I can see Italy having a bigger correction in the near future. If you've taken any speculative punts though, I'd think about locking in any profits if you haven't already. And build up your cash reserve for the opportunities that should hopefully arise from any big pile-up.

Interestingly, at the MoneyWeek conference last month, our guest speaker Russell Napier warned very explicitly that investors should avoid emerging market debt, or get out of it if they'd already bought in. To hear what else he and the rest of our speakers - had to say, you can buy a video recording of the entire conference here. But be quick they're only on sale until the end of the week.

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.