Swoon in Emerging Markets?

Is the Party over or Just Beginning?

Swoon in Emerging Markets?
November 5, 2014

Emerging markets have been difficult to predict in 2014, given the collective world instability and uncertainty. Emerging market stocks and funds have been through significant swings, leading to sometimes-contradictory predictions.

For example, the popular iShares MCSI Emerging Index Fund (NYSEARCA: EEM) has returned 0.22% for the year as of October 13th, but that includes a precipitous 7.5% drop in February, followed by an outstanding recovery to approximately 15% above the year’s starting value, and another precipitous drop in September/October, bringing us to the current value.

So what should we expect for the remainder of 2014 and into 2015?

We certainly are not in a position to predict emerging markets with certainty — if we were, we would probably be relaxing on an exotic beach locale by now. However, there are a few issues worth noting.

Emerging markets are by no means a continuous block. Within the BRIC (Brazil, Russia, India, and China), there is significant divergence. China’s growth and subsequent slowing has taken Brazil along for a ride because of Brazil’s large commodity market with China. Russia’s oil dependence and sanctions have taken it on a downward path, while India seems to be on a sustained growth run.

Judgments based on broad funds like the iShares are valid, but must be tempered by looking at the holdings. At the moment, the top holdings are still Chinese stocks, as well as Korean-based Samsung, which is also just recovering from a down period.

Further, events such as the recent oil glut and falling prices are going to have disproportionate effects within different countries as well as an overall effect on the global economy. For economies like Russia that are heavily dependent on oil, the news is worse than in manufacturing-based economies, where a drop in a basic raw material lowers fundamental manufacturing costs.

Even with this independence, it is true that the global economy can act as a more continuous block in response to certain events.

One major reason for the February tanking of emerging markets was the removal of large amounts of capital (around $11.5 billion) by investors who were concerned that the Federal Reserve would raise interest rates, thus throttling growth in emerging markets such as China. Since other important emerging markets as Brazil support China with commodity sales, the effect was expected to propagate through emerging markets.

This did not come to pass, growth in China surged, and as of early September, around $13.8 billion poured back into emerging markets as a result, prompting reports that emerging markets were back. Perhaps predictably in a contrarian sense, growth in China immediately fell, dragging down the overall emerging market. That is not the only factor bringing us to today’s emerging market stock prices, but it certainly is a major one.

Fed policy does seem to have the world stage at the moment, and it is reasonable to expect that when the Fed eventually does raise interest rates, there will be at least a knee-jerk (and perhaps longer-lasting) broad move away from emerging markets as capital flows back toward the U.S.

In short, it appears that the really big party may be over for a bit, and perhaps for a longer period depending on the world reaction to Fed actions at the beginning of next year — but in the meantime, there are some pretty good local parties that you may want to attend (speaking metaphorically about investments, of course).

If you are more of an active investor than a buy-and-hold investor, you may want to dig deeper into the performance of individual emerging market stocks and invest there, rather than in a broad-based fund. On the other hand, if you prefer buy-and-hold, then adjust your broader holdings accordingly based on which of the reports on the world economy you believe are correct.

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