Emerging Markets: Making Sense of the Meltdown

by Jeff Reeves | January 29, 2014 2:19 pm

As the old saying goes, the time to buy an asset is when there is blood in the streets.[1]

And there’s certainly plenty of red in emerging markets right now, what with chatter about Argentina on the brink of default[2], fears of a “shadow banking” crisis[3] in China and a dramatic rate hike[4] from Turkey’s central bank to stabilize the country’s currency.

Just look at these recent returns for an indication of how hard-hit emerging-market stocks have been:

But are these battered emerging markets truly a bargain after these deep declines, or are investors trying to catch a falling knife by buying into regions like these?

Emerging Markets: The Good

The biggest bull case for emerging-market stocks is simple: They are now relatively cheap, while U.S. stocks are relatively expensive after a big 2013 rally.

U.S.-listed foreign stocks (that is, ADRs on U.S. exchanges but headquartered overseas) indicate forward P/E ratios of 10 or less for South Africa, Hong Kong and South Korea[9] right now, just to name a few. That compares with a forward P/E of about 16 for the S&P 500 right now.

Furthermore, hopes of a Western recovery could bolster export-driven economies across South America and Asia. Europe exited recession last year, and America is seeing signs of hope as housing remains strong and the unemployment rate continues to drift steadily downward.

If you believe in a secular recovery for the U.S. and western Europe, than you have to believe economic growth will trickle down into emerging markets, too.

And even if you don’t believe in a big recovery for the developed world, according to the International Monetary Fund[10], emerging markets make up for about 40% of the world’s gross domestic product — so if you want to play growth, these nations are a big part of that.

Every investor should probably have some global markets exposure for diversification, and emerging markets clearly have a lot of growth potential … even if there is increased risk.

So why not consider staking out a claim after these deep declines, especially in a long-term portfolio? It’s very difficult to believe that these emerging markets won’t eventually bounce back, and a bargain buy now could pay off big-time down the road.

Emerging Markets: The Bad

Stocks are “cheap” now from a valuation perspective, sure. But that’s no guarantee that they won’t get even cheaper with deeper declines, or that depressed values won’t persist for weeks or months or even years in some markets.

The reality is that the Fed’s loose monetary policy hasn’t just inflated asset prices in the U.S., but it also has pushed cash into emerging-market debt, where yields were much higher — such as Argentina bonds with a 2033 maturity that carried rates over 13%[11] last fall, for instance.

And the prospect of winding down these easy-money policies means that cash will flow back into the U.S. once more, weakening stocks and currencies across emerging markets and increasing borrowing costs for many regions that were already pretty steep to begin with.

Consider that the Governor of Brazil’s Central Bank[12] recently lamented that a lack of a “coordinated exit from exceptionally loose monetary policies” was to blame for turmoil in both Brazil and its neighbors.

We can debate whether the Fed accurately telegraphed its intentions to emerging markets, and whether the pace of the “taper” will be manageable enough for EM governments to navigate the shift properly going forward.

But the bottom line is that the giant sucking sound in emerging markets is the flight of capital out of these nations thanks to slower growth in these regions and a shift in Fed policy in America.

Plus, there’s a chance this trend has not fully played itself out — that the pain will persist as savers and income investors leave riskier emerging-market debt behind and return to the safe and (hopefully) higher-yielding options at home.

Emerging Markets: The Ugly

Perhaps the most troubling facet of emerging-market investing right now is the threat of contagion.

The BRICs — that’s Brazil, Russia, India and China — all had a rough go in 2013, with all four regions finishing the year deeply in the red despite a roaring 30% gain for U.S. stocks last year. Their individual troubles became collective ones, then spread to smaller emerging markets and less developed frontier markets, too.

Consider China’s troubles weighing on commodity prices — and thus exports from mineral-rich nations across Africa, South America and the Pacific — as the prime example.

Or beyond the obvious, consider the scary analogy recently drawn between an embattled Chinese lender and Bear Stearns[13], and the fears of credit contagion as risky debt products have plunged in value and other institutions might need bailouts to stay solvent. The problems with debt and leverage in China could spread not only across this nation, but to related EM countries like Chile and Peru that have close financial ties to the Asian powerhouse and suffer credit risks themselves if things go south.

And just to throw gasoline on the fire, political unrest is a constant wild card.

I’m not just talking about the “desperate struggle” in the Ukraine[14] that has dominated headlines, either. Ukraine’s strife was born in part out of financial struggles and a lack of economic opportunity … and that narrative could easily play itself out in other nations.

The nightmare scenario for an emerging market is economic collapse that is quickly followed by a political collapse. And any investor holding the bag will see serious losses as a result.

These kind of meltdowns are admittedly rare, but they do happen … and EM investors need to always keep that in mind. Because while emerging-market stocks frequently have big growth potential, they also come with big risks.

Bottom Line: Be Discerning and Patient

I remain convinced that while there are big risks in China, this region is the tail that wags the dog and that if you believe in EM investing at all, you have to start with this mega-player instead of hoping naively that related economies in Asia or South America will thrive without a Chinese recovery.

I also think it’s worth noting that The New York Times just coined a new term to supplant BRICs and PIGS as the global fun club du jour — the “Fragile Five”[15] that consists of South Africa, Turkey, India, Indonesia and Brazil. These regions are clearly some of the hardest-hit right now, as is Argentina as it teeters on default.

My friend Ed Elfenbein probably said it best lately[16] when he urged investors not to paint all emerging markets with a broad brush. He wrote:

“I don’t know where all these recent EM developments are headed, but we’re going to soon find out who’s been responsible and who hasn’t. Mexico, for example, will probably pull through just fine. Poland as well. But I’m not so sure about others. Until then, we can expect a little more volatility in our markets and a lot more in the emerging markets.”

In other words, be patient and pay attention. Some regions are better than others, and this has to shake out for a bit longer before we will be able to separate the wheat from the chaff.

That’s not very satisfying, but it’s the truth.

Jeff Reeves[17] is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks.[18] As of this writing, he did not hold a position in any of the aforementioned securities. Write him at editor@investorplace.com[19] or follow him on Twitter via @JeffReevesIP[20]

  1. blood in the streets.: http://www.investopedia.com/articles/financial-theory/08/contrarian-investing.asp
  2. brink of default: http://www.nytimes.com/2014/01/29/opinion/argentina-on-the-brink.html?_r=0
  3. “shadow banking” crisis: http://www.cnbc.com/id/101370538
  4. dramatic rate hike: http://www.cnbc.com/id/101359309
  5. EEM: http://studio-5.financialcontent.com/investplace/quote?Symbol=EEM
  6. ILF: http://studio-5.financialcontent.com/investplace/quote?Symbol=ILF
  7. FXI: http://studio-5.financialcontent.com/investplace/quote?Symbol=FXI
  8. TUR: http://studio-5.financialcontent.com/investplace/quote?Symbol=TUR
  9. forward P/E ratios of 10 or less for South Africa, Hong Kong and South Korea: https://finviz.com/groups.ashx?g=country&v=120&o=name
  10. International Monetary Fund: http://www.marketwatch.com/companies/International_Monetary_Fund?lc=int_mb_1001
  11. carried rates over 13%: http://online.wsj.com/news/articles/SB10001424052702304795804579101591978033018
  12. Governor of Brazil’s Central Bank: http://www.cnbc.com/id/101364562
  13. Chinese lender and Bear Stearns: http://business.time.com/2014/01/28/is-china-about-to-plunge-into-financial-crisis/
  14. “desperate struggle” in the Ukraine: http://worldnews.nbcnews.com/_news/2014/01/28/22484103-desperate-struggle-in-ukraine-what-you-need-to-know-about-the-crisis
  15. “Fragile Five”: http://www.nytimes.com/2014/01/29/business/international/fragile-five-is-the-latest-club-of-emerging-nations-in-turmoil.html
  16. said it best lately: https://www.crossingwallstreet.com/archives/2014/01/the-emerging-markets-meltdown.html
  17. Jeff Reeves: http://slant.investorplace.com/author/profile/jeff-reeves/
  18. The Frugal Investor’s Guide to Finding Great Stocks.: http://www.amazon.com/dp/B007KB9CSI/ref=rdr_kindle_ext_tmb
  19. editor@investorplace.com: mailto:editor@investorplace.com
  20. @JeffReevesIP: http://twitter.com/JeffReevesIP

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