Buy the Dip from the Flight to Safety

While it may be tempting for investors to back out of Emerging Markets due to recent trends, now is in fact the time to buy, not sell.  

Due in large part to a USD appreciation on the back of Fed tightening, investors who have made bets on Emerging Markets have repatriated their capital, leading the MSCI EM Index into Bear territory on the year and the US Yield Curve to its flattest position in a decade. Generally, Emerging Market and USD performance are inversely-correlated, as many EM constituents are reliant on dollar-denominated capital inflows, which means that a USD appreciation will render borrowers less able to repay their debts. In fact, the negative correlation between the MSCI EM Index and USD performance is at a 2-year high (see chart below). 

 Country-by-country, this relationship should hold unless the Central Bank holds sufficient foreign exchange reserves to prop up the currency, or the economy is strong enough to withstand the rate hikes necessary to prop up the currency in the absence of Central Bank intervention. A third option is a cash injection from either the IMF or an ally willing to provide the capital needed to absorb liquidity. 

Turkey is one Emerging Market that has received significant international attention for their recent struggles. What started as a geopolitical feud between Turkey’s Prime Minister Recep Erdogan and US President Donald Trump has quickly flooded over into financial markets, wreaking havoc on Turkish debt and their domestic currency. International investors, worried that sanctions and political turmoil coupled with a gloomy economic outlook might put their investments at risk, withdrew their mostly dollar-denominated investments in Turkey, putting severe pressure on the Lira, down almost 20% on the month as the Turkish currency flooded the market. 

However, the outlook for Emerging Markets is not as inauspicious as their recent performance might suggest. While Emerging Markets are down almost 14% on the year (in USD), this number is almost halved (to 8%) when the performance is calculated in local currencies. This suggests that much of the underperformance is merely a dollar strength story. The combination of slowing growth, high private debt, insufficient foreign exchange reserves, a large and consistent current account deficit, and political uncertainty are what has caused the pressure on the Lira. And while many of these factors are not exclusive to Turkey (most are defining characteristics of Emerging Market economies), this particular combination of all factors is unique. Going forward, it appears the Lira is more the exception than the rule. 

Significantly, the underlying fundamentals that have driven Emerging Markets growth in past years have not changed. Emerging Markets are also taking further steps to provide support for their currencies. Indonesia, Argentina, and Hong Kong have all announced rate hikes, and most other Emerging Markets’ Central Banks have the reserves required to support their currencies should signs of a precipitous devaluation become apparent. Those who may not have the reserves required to prop up their currency are at less risk in case of a currency devaluation because they have not run large current account deficits (Chile), have relatively low private debt levels (South Africa), or have dynamic economies who can withstand rate hikes or a currency devaluation (Mexico.) The exceptions of Venezuela and Argentina are already experiencing a currency collapse similar to Turkey’s. 

Capital outflows and currency devaluations driven by the flight to safety have driven down Emerging Market equities and helped suppressed US yields. While Emerging Markets were already a sound investment, especially in the world of stretched valuations and negative real yields, the recent fall should signal buy, not sell. And despite the nearly inverted yield curve, the Fed should and will continue tightening in the face of full employment and increasing wage and price pressures. Although there has been some pushback regarding the Fed inverting the curve by tightening on the short end, some combination of Treasury Issuances, wage pressure from full employment, and price pressure from tariffs will push up the long end of the curve to give the Fed more room to work with. 

Given the increasingly negative correlation between USD appreciation and Emerging Market performance, further dollar appreciation is the main risk of remaining in Emerging Markets. A self-perpetuating cycle can occur if Central Banks raise rates to support their currencies to stymie downward pressure from capital outflows, which can weaken growth, thereby furthering investor outflows. But such a scenario is unlikely for two reasons. First, further dollar appreciation is unlikely. Many FX strategists believe the dollar is already overvalued, and further tightening is unlikely to be met with an appreciation commensurate to that of the past few months. Additionally, a bounce back in the price of gold, inflationary pressures, as well as sentiments from President Trump could be harbingers for a correction. Second, as mentioned, Turkey was uniquely susceptible to conditions leading to a severe devaluation. Most other Emerging Market countries can and will use the tools necessary to weather the storm should the dollar continue its strengthening. The risk of shrinking demand and a dry-up of liquidity from China is mitigated as President Xi seems to be shifting his focus from deleveraging to growth policies in the context of a burgeoning trade war with the US. 

The outlook for Emerging Markets is favourable. Investors have withdrawn money for fear of contagion from struggling Turkey, Venezuela, and Argentina. But this concern is primarily unfounded, and most of the spillover that has already occurred has been self-fulfilling (investors pull money, devaluing the currency, leading more investors to pull money, etc.) There are indeed certain political risks which can spillover into financial markets (see: Italy) but a few volatile political climates should not cause investors to write off Emerging Markets as a whole. Instead, investors should approach Emerging Markets with the due diligence they would any other investment, determine the amount of risk they are willing to tolerate, and invest in individual countries accordingly.