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Why Are Emerging Markets Submerging?

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Emerging market equities play an important role in many investors’ diversified portfolios due to their risk and return characteristics and relatively low correlation to other asset classes.  However, with the dollar-denominated MSCI Emerging Markets index down nearly 13% year-to-date and nearly 23% over the trailing one-year period as of Aug. 31, 2015, these long-term allocations have caused some discomfort recently. 

Because many investors appropriately include this asset class in their diversified portfolios, we believe it will be helpful to provide a few reasons for this underperformance.  In particular, we focus on China’s slowing growth and the impact of rising U.S. interest rates.  

China’s Slowing Economic Growth Rate

As China is the second largest economy in the world, it is no surprise that its slowing economic growth is weighing significantly on emerging markets. Several of China’s historical growth engines have been slowing of late. Manufacturing activity has fallen to its lowest level in six years. Slowing spending on real estate and construction, as well as reduced local government infrastructure spending, are also reducing growth.  China’s slowdown is directly reducing emerging markets’ economic performance, and expectations for slower future growth put downward pressure on equities. 

China’s slowdown is also being felt in emerging market economies that depend on Chinese economic activity, particularly those like Russia, Indonesia and Brazil, where commodity exports contribute significantly to economic activity.  Because China accounts for more than 30% of global consumption of several commodities, its slowdown significantly impacts global demand for these exports. In addition, as China’s economy continues shifting from commodity-intensive sectors to more services and consumption, downward pressure on commodities will likely continue to afflict major commodity exporters.

Interest Rates in the United States

Rising interest rates in the United States also put pressure on emerging market equity returns. Although the Federal Reserve recently declined to raise short-term rates, most expect that U.S. interest rates will begin to rise in the next year. Partly due to these expectations, U.S. 10-year Treasury rates have increased from below 1.75% in January to the recent 2.1%-2.3% range. 

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Rising U.S. rates have a direct impact on emerging market countries like China, whose currencies are managed to track the U.S. dollar.  Absent a spike in U.S. inflation, rising U.S. rates normally cause the dollar to strengthen relative to other currencies. Because currencies that track the dollar should strengthen, too, those countries’ exports become more expensive. 

Rising U.S. rates also negatively impact emerging market economies whose currencies are not pegged to the dollar. Countries that rely heavily on dollar-denominated financing should see their costs of borrowing rise because new loans will bear higher interest rates.  Existing dollar-denominated loans are affected, too. Because rising U.S. rates cause the dollar to strengthen relative to non-pegged emerging market currencies, the cost of servicing existing, dollar-denominated debt increases. That is because it takes more units of the currency to pay each dollar of interest and to repay each dollar of principal borrowed. Finally, countries with industries that depend on dollar-denominated commodities see their costs of production increase as their currencies depreciate relative to the dollar. Because dollar-denominated debt and materials are important to many emerging market economies, these results are felt broadly.

Finally, in September the Fed observed that “recent global economic and financial developments may restrain economic activity somewhat,” stoking investor worries about emerging markets  This announcement thus added downward pressure to emerging market equities in the weeks following. Emerging Market Equity Performance and Valuations

According to data from JPMorgan, in the year through Aug. 31, 2015, emerging markets are down 5.3% in their local currencies and 12.6% in dollar terms. Likewise, in 2014, currencies reduced a 5.6% positive return in local currencies to a 1.8% loss in dollar terms. As a result, many emerging markets equities have become cheaper, as measured by a composite of valuation metrics, relative to their historical valuations and to valuations across the globe. As of Aug, 31, the MSCI Emerging Markets index is at the bottom of its valuation range over the last 10 years.  In fact, equity valuations in Russia, China, Brazil, Turkey, Taiwan and Korea are all well below their 10-year averages and the global average.  Though no one can predict the future, it is important to remember that, historically, low valuations often preceded stronger subsequent returns. 

Rather than a knee-jerk reaction, investors should remain committed to the asset allocation strategies they selected based on their time horizons and risk appetites. A recent example illustrates the perils of acting rashly. In 2008, after returning 30%-40% in each of the previous three years, the MSCI Emerging Markets Index dropped 53.2%. The resulting pain could easily have prompted panicked investors to reduce their emerging markets exposures or even to eliminate them from their portfolios altogether.  But then they would have missed the next year’s extraordinary 79% rebound. An investment of $100 at the beginning of 2005 would have been worth about $117 after the 2008 crash.  Investors who refused to sell would have seen that value bounce back to nearly $209 at the end of 2009.  Remaining invested through the ups and downs between 2010 and 2015 would have left investors with nearly $232.

To be clear, we are not attempting to “call the bottom” on emerging markets equities; they may decline further. Instead, we want to emphasize the importance of keeping a calm, rational perspective.  This means staying committed to the long-term asset allocation.