Beware of cheap emerging markets

Emerging markets look cheap, but tread carefully – they tend to be highly cyclical and a global recession would weigh heavily on them.

This year has seen a “brutal sell-off” in emerging markets, say Marcus Wong and Melissa Cheok on Bloomberg. Emerging market dollar-denominated bonds posted the worst first-half showing since at least 1994; local-currency debt saw record losses and stocks tumbled the most since 1998.

Commodity exporters have been a bright spot, says Netty Idayu Ismail, also on Bloomberg. Soaring prices for energy, foodstuffs and metals made “the currencies and bonds of Brazil to Mexico and South Africa… the best performers among developing-nation peers in the first five months of 2022”. Yet even that trade has turned as materials prices soften on fears of an impending recession. The iShares MSCI emerging-market ETF has lost 19% so far this year.

“More pain for emerging market assets lies in store,” says Franziska Palmas of Capital Economics. Firstly, because rising interest rates and bond yields in developed markets will tempt capital away from emerging-market assets. “Second… a slowdown in global trade could weigh on emerging-market corporate earnings growth. Gloom on Wall Street will also carry over to emerging markets, which are perceived as riskier than developed ones.”

A more resilient asset class

A strong US dollar has fuelled fears of an emerging-markets crisis. “The archetypal emerging-market crisis was in 1997-98”, says The Economist. Rising US interest rates broke Thailand’s currency peg with the dollar. The resulting panic “floored South Korea and Indonesia” before wreaking further havoc in Brazil and Russia. Yet a repeat in 2022 is unlikely.

Today the emerging-market index is dominated by Asian giants such as China and India, which are “more self-contained financially, with state-led banking sectors and bond markets... largely closed to foreigners”. Only 16% of emerging-market debts are in foreign currencies; local banks do most of the lending. “Instead of sudden crises that spill back across borders and to Wall Street, many places face slower-burn and home-grown dangers: inflationary spirals or zombie banks.” Still, while emerging markets as a whole are less vulnerable to a crisis, there are a few exceptions.

Emerging markets have changed in other ways, too, says Andrew Ness of the Templeton Emerging Markets Investment Trust. The rise of Asia has brought diversification. “We’ve seen a transformation away from commodity-driven economies to… growth drivers that are much broader, like domestic consumption, technology and innovation.” The asset class increasingly contains world-class businesses, too. “Emerging markets have gone from being the followers to global leaders in... advancing technology.”

Emerging markets look cheap, but tread carefully, says Mohamed El-Erian in the Financial Times. A global recession would weigh heavily on emerging markets, which tend to be highly cyclical. Emerging-market bulls are also making the bold assumption that “the internal social and political fabric” of these countries “will be able to absorb a significant hit from prices of food and necessities”. There are some opportunities in emerging markets, “but rather than general investing by tracking indices”, the current climate calls for “a more selective approach” to placing your emerging-market bets.

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