Victims of 2018 – emerging markets

by , 7th January 2019

As 2018 drew to a close, it was fair to say that it had been a tough year for all asset classes – something like 80-90% of assets look set to end the year lower than where they started. Yet up until a couple of months ago, it didn’t look as though that was going to be the case.

As recently as early October, the US market had hit a fresh all-time high, despite a rough start to the year. And while UK stocks might have peaked in summer time, they merely looked as though they were taking a breather up until they followed the US market lower.

Instead, the real victims of the year had been emerging markets. The FTSE Emerging index peaked at the end of January and it has been sliding ever since. Emerging markets as a group officially tumbled into a bear market (shedding 20% from that January peak) in mid-August. Emerging market currencies have slid equally sharply over a similar period, resulting in a double whammy for investors in these markets.

Why the disparity? Emerging markets have faced plenty of problems this year, but that’s not especially unusual – a propensity for political and economic upheaval is one reason that these are emerging markets after all. One core issue lies behind the slide in emerging markets, and it’s the same one that has driven the more recent slide in developed markets. It’s all about tightening global monetary policy.

Firstly, and most obviously, this year has seen the Federal Reserve, the US central bank, raise interest rates several times. While Fed boss Jerome Powell now shows signs that he may be a little more circumspect in 2019, this has had the effect of driving the US dollar higher against most other global currencies this year. The Fed is not the only central bank to tighten this year – the Bank of England, the European Central Bank (which is ending quantitative easing) and even the Bank of Japan have all tentatively followed suit. But the Fed’s moves have been the most important.

That’s because the US dollar is the world’s reserve currency. All that really means is that the dollar is involved in the vast majority of cross-border transactions, and so pretty much every country needs to hold or be able to attain dollars in one form or another. If the dollar becomes stronger, that means dollars are becoming harder to get hold of – in effect, a stronger dollar represents a tighter monetary policy for the entire world.

When that happens, it’s the markets on the fringe who suffer first, just as when interest rates go up, it’s the most overstretched borrowers who get hit first and hardest. Remember that one of the big stories earlier in the year was all about mounting pressure on the likes of Turkey and Argentina, and other countries with a heavy reliance on external flows of capital? They had been accidents waiting to happen for years – the appreciating dollar and jitters about rising interest rates are what triggered the move.

The other big issue this year – perhaps a little less obvious – has been China’s efforts to rebalance its economy. Put simply, China’s financial system is a mess – there are bad or unsustainable debts everywhere, and the country wants to avoid major problems further down the road. So it is cracking down on lending too.

The problem is that since 2008, the global economy has – to an extent at least – been relying on a certain level of stimulus from China to keep the show on the road. So with both the US and China tightening monetary policy – not to mention the fact that they’re now engaged in a trade war, which has added to the pressure on China – the global economy is running out of growth engines.

So in a nutshell, that’s where we are: tighter monetary policy means that investors are taking risk off the table, and emerging markets have been among the assets to suffer the strain of that first. The question now is: will they also be the first to make a comeback in 2019? Or is this just beginning?

It all depends on the central banks

On the optimistic side, while emerging markets have suffered this year, we haven’t seen as much devastation as some had feared. For example, currency crises in both Turkey and Argentina were pretty much contained. And reaction to political change in both Mexico and Brazil has again been confined to those markets.

Meanwhile, history suggests that while emerging markets are often the first to go in a crash, they’re also the first to bounce back when markets regain their poise. For example, so far the emerging market index appears to have hit rock bottom in October, whereas developed markets are still plumbing new depths.

It’s also fair to say that emerging markets are inexpensive, particularly compared with their developed counterparts. There are signs that fund managers are starting to get interested in sniffing around.

On the other hand, things could get worse, no doubt about that. The trade war between the US and China could escalate next year. The dollar could continue to strengthen, even from these levels – it’s not impossible, though it’s very dependent on what message the Fed sends out to markets.

So what should investors do? I’ve always been a big believer in making buying decisions based on price rather than timing. If an asset is cheap and there’s no reason to expect a huge deterioration in fundamentals such as governance (applicable both to countries and companies) then if you buy, you should enjoy better-than-average returns in the long run. You might well have to be patient, but that’s how the best investors make their money.

Equally, both the US and China are under pressure to ease up on tightening. Sooner or later, one or both will crack. At that point, you’d expect markets to enjoy a rebound.

If you would like to increase your exposure to emerging markets, there are plenty of exchange-traded funds (ETFs) to choose from. Playing specific markets is one option but given how widespread the malaise has been, it probably makes more sense to build general exposure (which typically means a fair chunk of China mixed in with other markets) unless you have specific countries on your watchlist already. One of the cheapest options is the Vanguard FTSE Emerging Markets ETF (LSE: VFEM) which has an ongoing charge of 0.25%.

You can read more about emerging markets in Four top emerging markets ETFs.