The Emerging Markets were all the buzz this week, with India, Turkey and South Africa raising interest rates in an attempt to slow capital outflows. Since the 2008 crash, Emerging Market (EM) stocks have not been the same for US investors, significantly underperforming developed market stocks. Unfortunately I think they’re going to remain under pressure for a few more years as money continues to move into the US, but as I mentioned at the beginning of the month, EM’s shouldn’t be grouped together as a whole. Most investors and advisors make this mistake and simply allocate a certain percentage of their portfolio to one EM stock fund. This week is a perfect example of why that’s a mistake.
As a US investor, currency changes are a very large contributor to the performance in international investments. As a general rule of thumb, you always want your investments denominated in a currency that is appreciating. For example, if you own Japanese stocks and they go up by 10% but at the same time the Japanese Yen fell in value against the US dollar by 10%, your investment hasn’t changed in value; you lost in the exchange rate what you made in the stocks.
EM stocks tend to be volatile for two reasons: 1) EM currency exchange rates can be very volatile, and 2) EM’s are also the beneficiary of “hot money” that looks for high growth investments. So when times are good and money is pouring in, you get rising stocks prices AND a rising currency, but the reverse when liquidity dries up.
I typically like to look at EM countries as one of two categories, based on the structure of their economy: they either run current account surpluses or current account deficits. There’s a lot more to it than that but this is a good way to classify them to keeps things simple. The EM’s that run a deficit usually do so because they import more than they export (run a trade deficit) so they need to import capital to fund this by borrowing. The countries that run deficits are almost always the ones that come under extreme pressure when things slow, forcing them to intervene (by raising interest rates or using capital controls) to stop their currency from falling too quickly. But this is where the opportunity is! The time to buy is AFTER the currency has dropped in value (of after they’ve purposely devalued their currency). With a lower exchange rate, the rest of the world can now buy their goods at much cheaper prices, leading to an improvement in their trade balance/economy which then lifts their stock market. This is why you tend to see periods of strong performance after big negative years in EM stocks.
Most EM countries fall into the category mentioned above, but some run surpluses and don’t get hit nearly as hard. I think these are the countries to own because there is a natural pressure to lift their currency. Any country that continually runs a trade surplus should see its currency rise over time to correct this imbalance. Most times it’s rising in value because other countries are devaluing on purpose to boost exports. This is simply the cyclical nature of economies.
One country in this position is Singapore. For nearly the past 15 years, they’ve run current account and trade surpluses. And we’ve also seen the value of the Singapore dollar trend higher over this period, as it should. Their surpluses are still quite large which means its currency is still undervalued and due to rise over time. I purchased a small amount of Singapore stocks this week and will add to them if the Singapore dollar drops further. As for the EM countries that run deficits, this is where I think there’s more pain to come this year.
Here’s a chart of Turkey ETF (blue line) vs. Singapore ETF (black line) since the 2009 bottom:
You’ll notice how much more volatile Turkey has been because their currency experiences much bigger swings. The time to buy is after the big dips – but the question is: when is the “big dip” over…?
I hope everyone has a great weekend!
-Nick
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