September 13 2018 Market Update
Emerging Markets are in a Frenzy – but is it a Crisis?
Financial markets have been buzzing with speculation, concern, and even outright fear about emerging markets. You’ve probably heard about Turkey and Argentina, which are both in the middle of currency crises, and you may have wondered: how can two relatively small economies on two different continents generate so much news?
The answer is contagion. While Turkey and Argentina are facing different situations at home, investor fear has a tendency to run rampant in this asset class. Add the growing financial challenges that could be facing emerging markets as a whole, and you get a recipe for outsize concern about what’s next.
In this month’s newsletter, we’ll cover some of the key issues driving emerging markets performance this year, and what it means for your portfolio.
Overall, the MSCI Emerging Markets Index fell 7.18% for the year through August 31, compared with the S&P 500’s rise of 8.52% in the same period. There are a number of factors at work driving this performance, much of them tied to debt.
The first is the appreciation of the dollar, which has an immediate impact on the more than $3.7 trillion in dollar-denominated debt worldwide. With a stronger dollar, any dollar-denominated debt has immediately gotten more expensive for the nations and companies who have to service that debt with income from local currencies.
At the same time, the Federal Reserve has continued to increase the federal funds rate and wind down its balance sheet, which has pushed interest rates higher. The 12-month London Interbank Offer Rate, or LIBOR, already rose from 1.71% in August 2017 to 2.83% in August this year.
This has two effects: first, the price of existing debt is rising. But the cost of new debt is also rising. By one estimate, emerging markets borrowers will need to repay or refinance over $1.6 trillion in debt in 2019 and $1.5 in 2020. Obviously not all of this is in dollars, but with the overall cost of debt rising, too, there could be additional pressures coming.
Add local economic challenges to the picture and it’s no surprise people are getting worried. Consider the relatively large “BRICS “nations of Brazil, Russia, India, China and South Africa. Brazil is showing signs of systemic and economic weakness, and South Africa has just entered a recession. There are indications that international sanctions have started to take a toll on Russia’s economy, while China’s Shanghai Composite Index was down 17.6% through August 30, primarily on trade war fears. India’s currency, the rupee, just reached an all-time low relative to the dollar.
The result is a lot of talk about contagion.
Should I be Worried?
When financial professionals talk about contagion, they are generally referring to spillover effects in terms of financial or economic risks – for example, when a recession in one country has an impact on an important trading partner.
In this situation, we see the contagion risks as more behavioral than economic. Fear can create disproportional responses to specific risk factors, especially in emerging markets, and with yields rising here at home it’s relatively easy for investors in the asset class to jump ship.
Even in the absence of strong emotions, investors tend to treat all emerging markets as a single market, which means that strong fears about one can impact the performance of all. This is often a necessary simplification: most emerging markets are too small to justify large positions, or can be difficult to access cost-effectively.
But this means that even when an individual country’s exposure to risks like rising interest rates or trade war are not particularly high, that country can still be impacted by investor sentiment about those risks.
Key Takeaways for Investors
As with the Tech Titans we talked about last month, volatility in any single asset class can offer a poignant lesson in the benefits of diversification. While well-diversified investors have not captured the full 8.52% year-to-date gains in the S&P 500 through August 31, they are also more insulated against potential falls in the index – and to the rises and falls in every other asset class in their portfolios.
Over the long term, insulation from large swings in any one sector or asset class produces better overall performance. It also helps investors meet needs outside of monthly, quarterly, or even annual performance: after all, for most of our clients, investable assets have a larger purpose, such as providing immediate income, generating long-term wealth accumulation, or meeting philanthropic goals.
In our view, investors in emerging markets are likely in for some short-term volatility. But if you have invested in emerging markets, we have probably talked at length about the reasons why this asset class is typically more suitable for long-term investment rather than short-term income or lifestyle needs.
As a JSF Financial client, your portfolio has been tailored for both those short-term and long-term objectives, and we’ll work with you to adapt your investment policy as those objectives evolve.
Any single asset class may or may not have a role to play, but the appropriate approach will always remain the same: developing a sustainable strategy, focusing on diversification, and maintaining the discipline to weather even the most emotional markets.
Call us today if we can answer any questions about this month’s newsletter or to schedule your next investment review.
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The S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market.
10-year treasury note- is a debt obligation issued by the United States government that matures in 10 years. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.
The Bloomberg Barclays U.S. Aggregate Bond Index measures the performance of the total U.S. investment-grade bond market. The index includes investment-grade U.S. Treasury bonds, government-related bonds, corporate bonds, mortgage-backed pass-through securities, commercial mortgage-backed securities and asset-backed securities that are publicly offered for sale in the United States.
The MSCI Emerging Markets Index consists of 24 countries representing 10% of world market capitalization. The Index is available for a number of regions, market segments/sizes and covers approximately 85% of the free float-adjusted market capitalization in each of the 24 countries.
The MSCI Europe Index captures large and mid cap representation across 15 Developed Markets (DM) countries in Europe*. With 447 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe.
LIBOR is the average interbank interest rate at which a selection of banks on the London money market are prepared to lend to one another. LIBOR comes in 7 maturities (from overnight to 12 months) and in 5 different currencies. The official LIBOR interest rates are announced once per working day at around 11:45 a.m. In the past, the BBA/ICE published LIBOR rates for 5 more currencies (Swedish krona, Danish krone, Canadian dollar, Australian dollar and New Zealand dollar) and 8 more maturities (2 weeks, 4, 5, 7, 8, 9, 10 and 11 months).
LIBOR is watched closely by both professionals and private individuals because the LIBOR interest rate is used as a base rate (benchmark) by banks and other financial institutions. Rises and falls in the LIBOR interest rates can therefore have consequences for the interest rates on all sorts of banking products such as savings accounts, mortgages and loans.
Diversification does not eliminate the risk of experiencing investment losses.
 An interesting case in point: https://www.bloomberg.com/news/articles/2018-09-04/jpmorgan-survey-shows-how-quickly-emerging-markets-can-unravel, which shows how rapidly “favorites” can see sentiments change. Correlation coefficients across international equity markets have also trended higher over recent decades, as documented through 2012 here http://www.morningstar.co.uk/uk/news/96521/why-have-global-correlations-increased.aspx and through 2017 here https://www.investmentfrontier.com/2017/06/05/frontier-stock-market-correlations-2017/%20https://www.investmentfrontier.com/2017/06/05/frontier-stock-market-correlations-2017/ Notice the generally positive correlation between MSCI EM and individual economies. Academic reviews of herding and fear in international markets include https://pdfs.semanticscholar.org/11d5/1c86f51848bf4e10d0835f64eb783403f60b.pdf (an early work demonstrating differences between investor behavior in emerging and developed markets), https://www.sciencedirect.com/science/article/pii/S2212567115013970 (the effect of herding on valuations), and https://www.tandfonline.com/doi/abs/10.1080/1540496X.2016.1258357 (on the impact of fear on herding behavior).
 https://finance.yahoo.com/quote/^GSPC?p=^GSPC and https://www.msci.com/documents/10199/c0db0a48-01f2-4ba9-ad01-226fd5678111
 https://www.iif.com/system/files/iif_gdm_may_2018.pdf page 8
 Source: https://finance.yahoo.com/quote/000001.SS?p=000001.SS
 Source: https://www.bloomberg.com/news/articles/2018-09-05/hong-kong-stocks-head-for-biggest-drop-in-month-as-tencent-falls
 Source: https://www.businessinsider.com/indian-rupee-exchange-rate-hits-record-low-2018-9?r=UK&IR=T
 Source: https://www.bloomberg.com/news/articles/2018-09-05/jpmorgan-blackrock-warn-of-contagion-pummeling-emerging-markets please see (ii) for more detailed information about sentiment, herding, and fear-based selling.
 Source: https://finance.yahoo.com/quote/^GSPC?p=^GSPC