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Not that long ago, many emerging market countries were struggling with the “problem of plenty”. Ultra-low interest rates in the developed world coupled with higher growth prospects in these countries led to a surge in capital inflows. Massive inflows complicated monetary management and led to appreciation of currencies. (Read: Best ETF Strategies for 2014)
The beginning of the end of cheap-money era is now causing turbulence in these markets. As foreign investors head for exits, currencies of countries like Argentina, Turkey, Brazil and South Africa plunged to their multi-year lows and their stock markets swooned.
Further, many emerging countries profited from China’s enormous appetite for commodities in the past few years. Concerns about slowing growth in China as well the health of its huge shadow banking system are causing tremors in commodity exports dependent economies.
For some countries, factors are mostly internal—woes of their own making. Current crisis just exposed the structural problems that already existed in these countries. Their policymakers failed to address those severe problems when the going was good. (Read: 5 ETF Prections for 2014)
Unfortunately, in times of panic, inventors tend to lump and punish all emerging markets together. But looking at slightly longer-term picture, there may be some pockets of opportunity within the space. Investors need to focus on macroeconomic fundamentals and discriminate the stronger economies from the weaker ones.
A look at the Recent Performance
The broader emerging market ETFs Vanguard Emerging Markets ETFs (VWO - ETF report) and iShares Emerging Markets ETF (EEM - ETF report) are down more than 8% this year and many have fared worse. iShares Turkey ETF (TUR - ETF report) and Market Vectors Russia ETF (RSX) are among the worst performers—losing more than 11% this year.
On the other end of the spectrum, some smaller emerging markets/frontier markets did very well. Market Vectors’ Egypt (EGPT - ETF report) and Vietnam (VNM - ETF report) ETFs are up close to 11% this year.
Central banks in many countries rushed with several measures including rate hikes to stem the slide of their currencies and halt the exodus of foreign capital.
Turkey announced a massive rate rise but the respite for the beleaguered currency was rather short-lived. Indian rupee fared only slightly better after the rate hike. Brazil and South Africa did the same but the actions failed to help their currencies.
Which Countries are Most Vulnerable?
In my view, investors should avoid emerging countries from the following four groups.
1) Taper Tantrum: Countries that are dependent on foreign capital to finance their external deficits remain most vulnerable to the Fed’s tapering plans. Turkey, South Africa, Brazil and Indonesia look most risky looking at their current account deficits and external debt situation.
2) Structural Problems: Argentina and Venezuela are the easiest to classify in this group. Turkey and South Africa come to mind next. BRIC countries also suffer from some structural issues that will continue to cause problems going forward.
3) Political Uncertainty: All “Fragile Five” countries—Brazil, Turkey, India, Indonesia and South Africa—have general elections this year, which will keep these markets volatile. Countries like Turkey, Ukraine and Thailand are also facing political unrest, which makes their ride rough.
4) Dependence on China: Slowing demand in the world’s largest consumer of commodities does not bode well for countries like Brazil, South Africa and Indonesia. They have had their days in the sun and the picture looks cloudy now.
Is a repeat of 1997-98 Possible?
I don’t think that a full-blown financial contagion is on the horizon for emerging markets, even though volatility may continue to be high for quite some time.
The financial situation in emerging markets was very different in 1997-98. Many emerging countries have since accumulated large holdings of foreign exchange reserves, as they tried to halt the rise of their currencies in the face of strong capital inflows during the past few years.
Further, most of them have flexible exchange rates unlike in 1997 when countries with fixed exchange rate regimes were forced to devalue their currencies. Their financial markets are also much more mature now.
Any Bright Spots among Dark Clouds?
When the developed world was growing at a sluggish rate, domestic consumption driven developing economies like India, Indonesia and Turkey did pretty well. They may not do so well when domestic growth is slowing and currency woes will result in further decline in domestic demand.
On the other hand, countries that are leveraged to the growth in the developing world are likely to do better. The outlook for Mexico and South Korea has improved with that of their key export markets. (Read: Will the Mexico ETF shine in 2014?)
iShares Mexico ETF (EWW - ETF report) looks quite promising as of now due to significant reforms introduced by the Nieto administration and improving growth picture. Mexican Peso remains among the best performing emerging market currencies.
Encouraged by improving investment climate and significant reforms undertaken by the government, many large multinationals have announced huge investments in the country recently; the list includes PepsiCo ($5.3 billion), Cisco ($1.3 billion) and Nestle ($1 billion).
Looking at emerging Europe, Poland looks good, with its unexpectedly strong economic growth, solid fundamentals and rather resilient currency. Investors could consider iShares Poland ETF (EPOL - ETF report) or Market Vectors Poland ETF (PLND).
South Korea, with its record current account surplus, massive foreign exchange reserves and excellent institutional framework, could deliver excellent returns over long-term. WisdomTree Korea currency hedged ETF (DXKW - ETF report) is worth a look.
The Bottom Line
Emerging markets account for about 55% of global GDP in PPP terms. So a prolonged turmoil in these countries will impact the global financial markets. It is thus no surprise that spooked investors have been abandoning risky assets and seeking refuge in “safe havens”, leading to a sudden rise in the popularity of treasuries and gold.
Investors need to remember that one size does not fit all emerging markets. Current sell-off has created some long-term opportunities for investors who can differentiate between individual markets.
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