As the investing world has shifted from “risk on” (a mindset where traders are willing to take on additional risk in search of larger rewards) to “risk off” (a mindset where traders are more concerned with preserving their capital than making a large return on it), emerging markets have taken a beating.
Equities in emerging markets have more risk because they are typically smaller-cap stocks from less stable economies. This has made them prime selling candidates for any portfolio manager who has been looking to move to a more conservative allocation.
As you can see in the iShares MSCI Emerging Markets ETF (EEM) chart in Figure 1, emerging-market stocks reached their peak in September 2014 and have been in an accelerated downtrend since May 2015.
Figure 1 – Daily Chart of iShares MSCI Emerging Markets ETF (EEM)
However, EEM has seen a recent bounce during the past two months and is now sitting at an interesting inflection point. Are traders going to take on a little more risk in their portfolios and shift back into emerging-market stocks … or are they going to sell into strength and send EEM back down?
To help answer this question, we are going to look at the following three factors:
- Slower growth in China
- Falling oil prices
- Rising U.S. dollar
Emerging-Market Stocks and Slower Growth in China
The slowdown in the Chinese economy has been one of the primary drivers of the decline in emerging-market stocks. Of the top 10 holdings in EEM, five of them are Chinese companies — Tencent Holdings (TCTZF), China Mobile (CHL), China Construction Bank (CICHY), Industrial & Commercial Bank of China (IDCBY) and Alibaba (BABA) — and most of the others are affected by the Chinese economy.
As you can see in the annual growth rate chart of Chinese GDP in Figure 2, growth has been slowing.
Figure 2 – Annual Growth Rate of Chinese GDP (source Trading Economics)
Disappointing as they are, most analysts believe even these numbers are inflated.
When the Chinese economy slows down, it hurts not only emerging markets, which provide the raw materials that feed the Chinese industrial machine, but also those markets that sell goods and services to a burgeoning Chinese middle class.
If the Chinese economy can stabilize, it will provide a solid foundation from which many stocks in emerging markets could recover.
Emerging Markets and Falling Oil Prices
One of the reasons equities in emerging markets have been underperforming is the close relationship many of them have with the price of oil. Companies like China’s CNOOC Ltd. (CEO) and India’s Reliance Industries are directly impacted by falling oil prices.
Looking at the crude oil futures chart in Figure 3, you can see the dramatic decline we’ve seen in oil prices during the past few months.
Figure 3 – Daily Chart of Crude Oil Futures
Oil has been falling since July 2014, but it may be starting to show some signs of life after dipping momentarily below $28 per barrel.
If oil prices can rebound, it would take a lot of pressure off of the stocks in emerging markets with direct exposure to oil prices. It would also take a lot of pressure off of the emerging economies — like Brazil and Russia — that are heavily affected by the price of oil.
Emerging Markets and the Rising U.S. Dollar
The U.S. dollar started its meteoric rise in July 2014, and has remained elevated for the past year (see the PowerShares DB U.S. Dollar Index Fund [UUP] chart in Figure 4).
Figure 4 – Daily Chart of the PowerShares DB U.S. Dollar Index Fund (UUP)
The rising U.S. dollar has hit emerging markets in two ways.
First, it has dramatically cut the value of commodities, most of which are priced in USD in the global marketplace. So, when the dollar moves higher, it pushes commodity prices lower because commodity producers are able to receive more of their native currency when they exchange a strong USD, so they demand less of it.
Conversely, when the U.S. dollar moves lower, it pushes commodity prices higher because commodity producers aren’t able to receive as much of their native currency when they exchange a weak USD, so they demand more of it.
As you can see in the PowerShares DB Commodity Index ETF (DBC) in Figure 5, commodity prices have been in a steep downtrend since July 2014.
Figure 5 – Daily Chart of the PowerShares DB Commodity Index ETF (DBC)
Since many emerging-market economies are heavily dependent on commodity exports — whether it be oil or industrial metals, wheat or coffee — low commodity prices are putting quite a dent in export revenues.
Second, the rising dollar is hurting foreign governments and foreign companies that have taken out loans denominated in USD.
For instance, if a Brazilian firm took out a loan denominated in USD in mid-2014, when 1 Brazilian real (BRL) was worth ~45 cents, that same Brazilian firm would have to generate nearly twice as much revenue to make its monthly payments now that 1 BRL is only worth ~25 cents (see the BRL/USD chart in Figure 6).
Figure 6 – Daily Chart of the Brazilian real / U.S. dollar (BRL/USD) Exchange Rate
Naturally, it is much more difficult for a company to generate a profit and maintain its margins when its debt payments nearly double in the space of a little more than a year … which makes its stock look even less attractive.
The Bottom Line for Emerging Markets
We’re starting to see some signs of life in emerging markets, but we haven’t turned the corner yet. Too many of the same fundamental factors that pushed emerging market stock valuations down in the first place are still with us today. This bullish move could continue to develop, but keep your eye on the fundamentals.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
