The policy decisions made by America’s central bank the Federal Reserve and the related rise or fall in the dollar are perhaps the most significant moving parts in the engine of the world economy.
As such, all nations around the world are affected by them. However that impact is not evenly spread and one section of the investment world is particularly vulnerable to the Fed’s decisions.
Emerging markets are typically much more dependent on the dollar than the non-US developed markets.
The port in Argentina’s capital city, Buenos Aires.
The principal reason for this is that in many cases their debts are largely in dollars rather than their own sovereign currencies.
The US economy is strong at the moment, and seems set to keep strengthening. This means the Fed will likely have to keep raising rates a fair clip to keep inflation in check, and therefore the dollar will keep rising.
As the dollar goes up relative to an emerging country’s domestic currency, its debts therefore effectively grow and become more expensive to service.
Argentina has been roiled by the strengthening dollar recently and there is a full-blown economic crisis there. The country is in the process of going cap in hand to the International Monetary Fund, the last resort safety net for nations struggling economically.
While there are also underlying fundamental problems in the Argentine economy such as a big government overspend under former President Cristina Fernández de Kirchner, it’s the relationship with the dollar that is the biggest driving force behind the recent uptick in trouble.
What are emerging markets?
The term emerging markets refers to the countries around the world that have an economy of significant size and variation, but to a lesser extent than developed markets such as those in Western Europe, North America, Japan and Australasia.
There is no single definitive list of emerging markets which is agreed on by all, but the following countries will be included in most cases; Argentina, Bangladesh, Brazil, Bulgaria, China, Colombia, Czech Republic, Egypt Greece, Hungary, India, Indonesia, Iran, Israel, Malaysia, Mauritius, Mexico, Nigeria, Oman, Pakistan, Peru, Philippines, Poland, Qatar, Romania, Russia, Slovenia, South Africa, South Korea, Taiwan, Thailand Turkey, Ukraine, United Arab Emirates, Venezuela and Vietnam.
A subset of the most populated emerging markets dubbed the BRIC countries –Brazil, Russia, India, China – is also still commonly referenced, however this is increasingly seen as a defunct grouping due to the large differences between these four.
Economies which are even earlier in their development than these are known as ‘frontier markets’ and include such places as Sri Lanka, Togo, Mali and Ivory Coast.
It has been a double whammy for the Argentine peso, with the dollar strengthening due to Fed policy and a motoring US economy as the peso falls due to investors losing confidence in the country’s economy. This has led to runaway inflation.
In Turkey things are not looking rosy either. The Turkish lira has plunged in value recently as financial markets have taken fright at its large national debt and ongoing borrowing needs. As the dollar rises so these debts get all the more daunting.
If Argentina and Turkey are in fact ‘the canary in the coalmine’, other emerging markets are on borrowed time before they see big trouble.
The key question therefore is whether or Argentina and Turkey are simply the first of many to hit the skids or will be isolated cases.
Should you therefore bail out on any emerging markets funds you have invested in before the dominos all fall?
The difficulty in answering this with certainty is that the asset class is so broad and various emerging markets are very different from each other.
The term ‘emerging markets’ seems to be holding on in common use principally because there is no obvious other way to readily categorise these various countries in a convenient way.
It is fair to say that across emerging markets a stronger dollar is a headwind to some degree because of the fact that they have dollar-denominated debts, and therefore yes, other countries could follow Argentina and Turkey into dangerous waters. South Africa and Brazil also look very vulnerable for similar reasons.
The other side of the dollar strength coin however, is that a stronger dollar makes the exports of emerging markets more competitive and so helps their economy, trade barriers allowing.
The key factors in determining how well a developing economy can weather a rising dollar are the size of their debts relative to how much they are able to export, how robust their domestic economic activity is, and how stable they are politically.
There will be big variations in these across the various countries so we can say that Argentina and Turkey are not representative of the whole group.
The Turkish lira has plunged in value recently as financial markets have taken fright at its large national debt and ongoing borrowing needs.
There is also the fact that at the individual company level a wide variety of factors can impact the share price which can be partially or totally independent of the host nation’s underlying economy.
There will be plenty of winning companies still even if the asset class as a whole is facing tougher times.
While some added caution is necessary, bailing out on emerging markets investments completely at this point would seem an unwise overreaction, particularly if you have a long-term outlook.
There may well be short-term difficulties for the asset class, but emerging market stocks are often the fastest growing and can deliver the best returns over the long term.
If you are nearing retirement it may be wise to taper down any holdings, however if you have plenty of earning years ahead of you emerging markets should be part of your investment pot and sticking with the asset class will pay off.