Emerging Markets Tough Puzzle To Solve

Emerging Markets Tough Puzzle To Solve

Much has gone wrong in developing markets lately. What spots of hope are left?

Reviewed by: Lara Crigger
Edited by: Lara Crigger

[This article originally appeared in our May issue of ETF Report.]

For emerging market investors, 2015 landed one sucker punch after another.

China’s slowdown. Brazil’s Petrobras scandal. The Syrian refugee crisis. All that and more coalesced into a perfect storm that battered broad-based EM funds last year, including the two leading ETFs, the Vanguard FTSE Emerging Markets ETF (VWO | B-95) and the iShares MSCI Emerging Markets ETF (EEM | B-100), which plummeted 15.8% and 15.4%, respectively.

All that said, both funds rallied more than 10% in March, their best monthly performance since 2012. The drivers behind that, though, had more to do with a falling dollar and a U.S. stock market rally than the head winds they’ve been fighting. All of this certainly has investors wondering how they should approach this space.

China’s Economy Pumps Its Brakes
Several poor fundamentals plagued developing markets in 2015. None was as damaging, however, as China’s economic slump.

For the past decade, China’s role as the world’s factory has fueled its more than 10% annual growth rate and nourished demand for raw commodities in other developing countries worldwide. But the larger an economy grows, the harder it is to keep growing. So it was inevitable that China would slow down eventually—and it finally happened in 2015.

Why last year? The reasons are manifold, but one of the biggest is China’s massive credit overhang. During the 2008 financial crisis, Beijing shelled out $586 billion to keep its economy afloat. While this stimulus package let China strong-arm its way through the global downturn, it also left the country with an enormous debt burden. By 2015, the nation’s total debt (including that from the government, banks, corporations and households) had skyrocketed to well over 250% of GDP.

Further cuts to the cost of borrowing in 2014 didn’t help matters. Nor did monetary policy in which China’s central bank let the yuan depreciate sharply in 2014, only to then intervene with six rapid-fire rate cuts over the next year.

Complicating matters is China’s looming labor shortage. The country’s mammoth manufacturing sector depends on cheap, plentiful labor, but that’s become increasingly difficult to come by given an aging workforce and a youth population uninterested in lower-paid factory jobs. As a result, the country suffers from overcapacity and oversupply, and has seen its pace of exports slow.

To deal with this, China’s government has introduced fiscal reforms designed to transition the country from a production economy to a service-based one, while also simultaneously attempting to preserve political stability. It’s a delicate balancing act, though, and the penalties of failure are steep.

“China is very diverse, in terms of wealth and ethnicity,” said Ken Shaw, senior vice president of Envestnet | PMC. “Tens of millions of people left the countryside to go work in these factories, and if they shut down, there could be social unrest. That worries the Chinese government. It’s something it’ll try to protect against, even if it means making long-term sacrifices for short-term stability.”

All these factors culminated in 2015, in which China posted its slowest growth rate in 25 years. This year isn’t looking much better: The IMF predicts a 6.3% growth rate, a stark decline from the past.

What Happens In China Doesn’t Stay In China
China’s slowdown has sent aftershocks trembling through many other emerging markets, particularly commodities-producing countries. In better times, these economies boomed due to China’s insatiable thirst for raw materials, such as iron ore, coal and oil; and many grew dependent on China as its largest trading partner. Therefore, evaporating Chinese demand and the consequent plunge in commodities prices threaten to destabilize these markets today.

“You’ve got places, like Nigeria, where the entire economy is no longer profitable, because it costs more to get oil out of the ground than they can sell it for,” said Kevin Carter, CEO at Big Tree Capital and the man behind the Emerging Markets Internet & Ecommerce ETF (EMQQ | D-25).

“It’s wreaked havoc on their currencies and economies.”

Nowhere is safe. African emerging markets have taken massive hits to their export levels. Recessions have arisen in Latin and South America, including Brazil, Venezuela, Peru and Chile. Even more developed markets are not insulated: Australia, Korea, Japan, Thailand and Taiwan have all struggled to cope with declining Chinese demand.

Compounding the issue is a strengthening U.S. dollar, which hurts emerging markets twofold. First, their cost to import goods rises as the value of their exports fall, leaving them less capital on hand to handle, say, a food shortage—a scenario that currently threatens drought-stricken South Africa.

Second, many emerging markets—such as Turkey and Indonesia—hold a generous portion of their government debt in U.S. dollars. “When the dollar was cheaper, these countries borrowed heavily from the U.S.,” Shaw said. “Now these countries must meet a much bigger burden to make their debt obligations.”

What A Difference An Index Makes
Poor fundamentals alone may not explain all the pain that emerging market investors experienced last year. Some experts suggest it also comes back to how investors initially accessed these countries.

“Broad-market emerging market ETFs are a terrible way to make money off emerging markets,” said Carter. “They’re just structurally flawed.”

Emerging Global Advisors’ Vice Chairman and Chief Investment Strategist Ed Kerschner agrees. Large indexers operate on ancient classifications of what constitutes an emerging market, he says; MSCI, for example, still classifies South Korea and Taiwan as emerging markets. “The World Bank reclassified these as developed economies in 1997,” said Kerschner. “So why are we still putting them in an emerging market index? What, exactly, is emerging about Samsung or Taiwan Semiconductor?”

Furthermore, adds Carter, emerging market indexes tend to overweight state-owned enterprises (SOEs), like China Mobile or Petrobras. These companies are not necessarily driven by profit motive, and are often inefficient and corrupt. “When management shows up to work on Monday, ‘maximize shareholder value’ isn’t on its to-do list,” Carter said.

Indexers also tend to overlook sectors currently booming in emerging markets, such as e-commerce companies, because many of these stocks are domiciled in the U.S. rather than domestically. “The best growth story in the emerging markets is these Internet companies,” said Carter. “But for archaic, technical reasons, they’ve been left out of these indexes.”

Opportunities Abound
What the future holds for emerging markets depends on who you ask. Some, like Kerschner, hold a sunny view on the space, citing strong growth projections, domestic fiscal stimulus and reform packages in the works across many countries.

“The emerging market consumer is the biggest story of our lifetime,” he said, citing research from Morgan Stanley that says by 2030, India and China could represent as much as 41% of global middle class spending.

Shaw, meanwhile, encourages investors to embrace emerging markets more carefully, though he’s still optimistic about the sector’s long-term prospects.

“From a valuation perspective, emerging markets look pretty reasonable right now,” he said. “If you’re a short-term investor, though, you have to be more selective about where you place your bets.”

Lara Crigger is a former staff writer for etf.com and ETF Report.