Emerging Markets Tail Wags Dog

Concerns about a slowdown in China’s economy appears to be the ‘go-to’ rationale for the selloff, although there hasn’t been any new data since the Purchasing Index Managers (PMI) report that we discussed on Friday.

A secondary, but possibly more plausible explanation is that investors are looking at the weakness in Emerging Markets currencies and are concerned about the end of the Federal Reserve’s quantitative easing program.

We noted the 16 percent decline in the Argentinean peso last week, and while that was the worst performer by 10 percentage points, it wasn’t alone in its decline.  Currencies like the Turkish lira, South African rand, Brazilian real, Indian rupee and Russian ruble all lost value.

What’s going on?

Over the last decade, emerging markets have benefitted from strong capital inflows from investors in developed markets for a variety of reasons – higher expected growth rates, meaningful interest differentials and an appetite for risk-taking.

Granted, there was a meaningful pause in 2008 when risk aversion took hold, but the capital flows came flowing back in 2009 according to IMF data.

Right now the capital flows are out of emerging markets because the three factors that allow for high inflows are now in reverse.

China’s growth is slowing down and weak demand for commodities from the developed world have demand from commodities exporting countries like Brazil, Russia and South Africa.

Interest rate differentials are also lower and could continue to shrink as the Federal Reserve begins to slow down their bond-buying program known as quantitative easing.

The Fed has been buying $85 billion in US bonds each month through the program, although they decided last month to reduce the program by $10 billion per month and is expected to reduce the program again by another $10 billion per month this week.

Last week, we asked whether it was time to exit emerging markets (hyperlink above) and we don’t believe that’s the right call for three reasons.

First, we still believe that emerging markets will continue to grow thanks to their growing populations and burgeoning middle class.

Second, the valuations are interesting compared to their historic levels and compared to other developed markets and the US.

Third, we think that investors should earn a slight risk premium for the political risks that exist in emerging markets.

If you’re wondering whether emerging markets are ‘the canary in a coal mine’ and think we should exit stocks altogether, we think that’s a mistake too.

Volatility is spiking, as evidenced by the 40 percent increase in the CBOE Volatility Index (VIX), but it’s only gained to normal long-term levels from unreasonably low levels.

Market volatility is normal and expected and so are market declines.  In addition to the extremely low level of volatility last year, we didn’t have any meaningful drawdowns either.

A drawdown is peak-to-trough decline during a specific period that’s quoted in percentage terms.

Since 1950, the S&P 500 experienced a drawdown of between 10-15 percent, known as a correction, in nearly a quarter of all years.  A bear market, or drop of 20 percent or more, occurred in almost 20 percent of all years since 1950.

It’s true that a flare-up like this one is always disconcerting, but flashes like this happen all of the time.  You never know which one will ‘get legs,’ but for the most part, they fade away and are forgotten.