Recently, Jarrett Oakley, director of marketing sat down with John Steele, director of investments at JOYN, to discuss the turbulence surrounding emerging markets and to break down the status of the asset class. Below please find their Q+A discussion.
“So John, where do we stand today in emerging markets?”
Emerging markets have experienced a volatile 2018, entering bear market territory (defined as a 20 percent drawdown from peak level) after falling 25 percent between late January and the end of October. The decline is familiar to investors who experienced the 35 percent decline that culminated in January 2016, following concerns of liquidity and economic growth in China.
“What have been the main reasons for the selloff?”
It is difficult to point to a single event this year that has caused the decline in emerging markets. The selloff is attributed to multiple factors including a stronger U.S. dollar, political rhetoric on tariffs, debt concerns, worries about global economic growth, and flight of capital from a few countries experiencing fiscal and currency crises.
“What is the impact of tariffs?”
A hot topic for much of 2018 has been the negative effect of tariffs on global trade and the protectionist stance taken by the Trump administration. While increasing government revenue can be a positive for current accounts, the tension it creates can be negative. The issue stems not only from the fact that goods and services become more expensive, but also the potential for deteriorating diplomatic solutions.
“What impact does the dollar have on emerging markets?”
Since early 2008, the U.S. dollar has strengthened by 42 percent against a broad basket of developed market currencies.
This has been the longest and largest period of appreciation since June 1995 when the U.S. dollar had a similar run, strengthening 39 percent over a period of 6 years. The table to the left shows the year-to-date depreciation of notable emerging markets economies versus the U.S. dollar.
The impact is two-fold. Not only does an appreciating U.S. dollar offset local dollar returns when converted back to U.S. dollars, it increases the cost of debt for countries who have borrowed in U.S. dollars.
For example, let’s say a country borrows $100 million and the exchange rate is 2.0 (2 units of local currency = 1 USD). If the local currency subsequently depreciates 5 percent against the U.S. dollar, it now takes 210 million units of the local currency to repay the debt. This can quickly become problematic, particularly for countries that see sharp and unrelenting declines in their currency.
“Why is the U.S. dollar strengthening and will it persist?”
The strength of the U.S. dollar can largely be attributed to demand for U.S. denominated assets – namely bonds. With nominal yields in other developed markets such as Japan and core Europe so low, droves of investors have come in to scoop up U.S. dollar denominated debt. This investor movement forces the sale of another currency and the purchase of U.S. dollars – causing demand to outstrip supply.
The 2014 “taper tantrum,” followed by a sharp strengthening in the U.S. dollar, sent interest rates higher as the United States signaled tightening when most every other country around the world was loosening their monetary policy. Further, as U.S. dollar-denominated debt becomes more expensive in local currency, there is a frantic effort to increase foreign currency reserves or swap foreign currency for U.S. dollars in the open market. This increases demand and continues the U.S. dollar momentum.
However, we believe that the U.S. dollar’s strength of the past decade is unlikely to persist as central banks around the world continue to shift their monetary policy directionally in-line with the Federal Reserve.
“What are key risks for further pressure on emerging markets?”
While emerging markets have seen significant pressure thus far, there are some headwinds that could persist in the near term. Sustained strength in the U.S. dollar is the primary risk along with concern over China’s economic growth and development. The rise of passive investing, due to the incorrect perception that “what is bad for one is bad for all,” has exacerbated recent volatility. It is among the many reasons we recommend an active approach within emerging markets.
“What is the outlook for Emerging Markets as an asset class?”
Research shows that valuations drive the long-term performance of asset classes. Currently, companies within the MSCI Emerging Markets Index have a weighted average price-to-earnings ratio of 13.0x. This is below the 10-year average ratio of 14.0x and sits significantly below where the S&P 500 currently stands at 21.0x. Ultimately, this means that emerging market stocks are less expensive than both their historical average and current S&P 500 companies.
It is no secret that emerging markets can experience a roller-coaster ride of highs and lows. With higher risk comes higher reward, but it is important to carefully control a portfolio’s exposure to asset classes that exhibit higher levels of volatility. JOYN’s proprietary asset allocation model currently allots 5% to emerging markets in a “balanced” portfolio which is designed to take a medium level of risk.
While emerging markets have experienced a bout of underperformance, the rationale for allocating to this asset class remains. Emerging markets are attractively priced and offer additional benefits to portfolios, including a low correlation to other asset classes—as this diversification benefit reduces the overall risk (volatility) of the portfolio over time.
Investment Advisory Services offered through JOYN Advisors, Inc. Registered Investment Advisors. Insurance offered through JOYN Atlanta, Inc. Securities offered through Securian Financial Services, Inc. Member FINRA/SIPC. JOYN Advisors, Inc. and its affiliates are not affiliated with Securian Financial Services, Inc. This email and any attachments are intended only for the use of the individual addressed and may contain privileged and confidential information.
 Bloomberg, as of 9/30/2018