Biggest Threats To Emerging Market ETFs

Is this a buying opportunity, or the start of a bear market?

[This article appears in our August 2018 issue of ETF Report.]

The emerging market (EM) story is facing strains. After a stunning rally in 2017 that took the MSCI Emerging Markets Index up by 37.3%, stocks of developing countries have struggled so far this year. The index briefly hit a decade-high in January before steadily dripping lower to last trade with a year-to-date loss of 6.7%.

ETFs tied to emerging markets, like the $46 billion iShares Core MSCI Emerging Markets ETF (IEMG) and the $59 billion Vanguard FTSE Emerging Markets ETF (VWO), have followed suit to the downside, raising sharp divides in the analyst community about whether this is a buying opportunity or the start of a more severe downturn in the asset class.

On one side, you have analysts like those at UBS, who see "solid rally potential" in emerging market equities, while on the other, you have analysts like those at Morgan Stanley who expect an "outright bear market" for EM.

Rising Dollar Sinks EM

No matter which side of the debate they land on, analysts tend to agree on one thing―a rising dollar is negative for emerging market equities. Since the start of 2018, the U.S. Dollar Index has climbed nearly 3% to last trade near a one-year high.

A climbing dollar hurts returns for U.S. investors who invest in emerging market stocks, which are typically denominated in emerging market currencies.

"When the dollar is rising, it tends to bring money back towards the U.S." as  "investors take off the risk trade," said Geoff Dennis, head of global emerging markets strategy at UBS. EM traditionally does very poorly during times of a rising dollar, as investors "pick away at the weaker stories within emerging markets," he added.

In addition to hurting investors' returns, a stronger dollar: makes it more difficult for emerging market countries to finance their dollar-denominated debts; reduces foreign investment in emerging markets, hurting economic growth; and tends to weigh on EM foreign currency reserves as central banks draw them down to stabilize their domestic currencies.

The dollar's pull on emerging markets is so powerful that even bullish analysts such as UBS' Dennis concede that, were the greenback to rally further, the outlook for the asset class would be severely challenged.

Trade War Uncertainty

Closely tied to the rising dollar (and equivalently, falling emerging market currencies), are sharply rising interest rates. To stem the decline in their currencies, central banks from Turkey to India to Indonesia have recently hiked rates.

All else equal, higher rates are a drag on growth.

Adding to the growth worries is the ongoing trade war between the U.S. and China―one of the biggest risks not just to emerging markets, but the overall global economy. As of July 3, the U.S. was set to begin collecting tariffs on $34 billion worth of Chinese goods on July 6, and that could just be the tip of the iceberg if President Trump follows through on his most damaging threats.

A trade war is certainly not a good thing for the world's second-largest economy and the world's largest emerging market. However, at least now, it's too early to say that the nascent trade conflict will jeopardize China's official 6.5% GDP growth target.

Instead, the biggest threat of the brewing trade war may be the uncertainty it creates for China and emerging markets in general.

"While the direct round-one macroeconomic impact in terms of GDP reductions is likely to be quite small, we don't know where this is going to stop, and these things are often quite complex in how they feed through into the overall economy," explained Jonathan Garner, chief emerging market strategist for Morgan Stanley.

"Given that degree of uncertainty, we marked our multiple assumptions lower across the board," he added. Garner has a 1,000 target on the MSCI Emerging Markets Index, 5% lower than current levels.

Positive Fundamentals

Not everyone is convinced that uncertainty is enough of a reason to abandon emerging markets. UBS' Dennis believes that emerging markets' positive fundamentals remain largely intact.

According to him, the sell-off in EM currencies has been relatively narrow, with weakness contained to countries such as Turkey, Brazil, Mexico and others―not the type of indiscriminate selling one would expect if fundamentals were truly deteriorating.

Likewise, he says GDP downgrades among emerging markets have been fairly limited. In fact, there have been more upgrades than downgrades, with overall economic growth for the group as a whole still expected to exceed 5%.

Earnings growth is also anticipated to be robust. The consensus still sees profits for emerging market companies growing by 15.9% this year, while UBS sees even better growth of 18%.

A Lot More Cracks

Of course, the outlook for EM today may be very different than the outlook for EM tomorrow or months down the line, if certain negative risks materialize. That's what Carmen Reinhart, professor of the international financial system at Harvard University, fears.

She recently told Bloomberg that the outlook for EM has "a lot more cracks than it did five years ago" due to both external and internal conditions. Reinhart said the group is particularly vulnerable to a rising dollar and borrowing costs because more than two-thirds of emerging market debt is dollar-denominated.

Even debt denominated in local currencies is at risk because "internal debt is increasingly being held by nonresidents, making for bigger spillovers," she explained.

Meanwhile, many lower-income EM countries, such as those in sub-Saharan Africa and the Middle East, "have become indebted to China" and "will have a lot of debt-servicing difficulties," Reinhart added.

The Harvard professor stopped short of calling for doom and gloom, but said EM has a lot of vulnerabilities―especially Argentina, which is likely to see a serious recession imminently, in her view.

Little Risk Of Funding Crisis

The analysts at Research Affiliates have a completely different interpretation of the risks for emerging markets. They agree:  Argentina is a high-risk country (and, incidentally, one that won't officially be incorporated into the MSCI Emerging Markets Index until next year). Turkey, Indonesia and a few others also fit into the “high risk” bucket.

But add all those countries together and they only account for less than 20% of the MSCI Emerging Markets Index. Another 20% of the index, including Brazil, Mexico and South Africa, they deem ”moderate risk,” and a full 60% of the index, China, India, Korea and Russia included, are considered “low risk.”

According to the analysts, none of these big emerging markets presents "any measurable risk of a funding crisis." Additionally, "all have low external-debt-to-GDP ratios and ample FX reserves, and most run current account surpluses," they added in their recent commentary.

Valuation isn't a reason to worry, either. The analysts say that prior to the '97-98 emerging market crisis, the cyclically adjusted P/E ratio for emerging markets was higher than that of the U.S. Today it's less than half that of the U.S.

"When the risks and the bad news are well-known to the market and fear reigns supreme, it’s time to buy, not sell," they concluded.

Email Sumit Roy at [email protected] or follow him on Twitter sumitroy2