Differentiating Between Emerging Markets For Better Returns
Summary Emerging markets are often grouped together, but it’s better not to. Changes in monetary policies may be upon us and some countries should do better than others. Countries with sizable deficits are more likely to experience problems and should be avoided. The year 2015 has been a forgettable one so far for many emerging markets. For instance, the iShares MSCI Emerging Markets ET F (NYSEARCA: EEM ), which is the leading ETF for emerging markets is down by 11 percent this year when it comes to liquidity. By comparison, stock markets in countries such as the U.S. and Japan are at record levels. Some people may therefore feel that emerging markets are more of a bargain and have more upside still left in them. A long position in emerging markets is an option worth exploring from this standpoint. On the other hand, some may argue that the worst is not over for emerging markets and there is still some downside left. Avoiding long positions or even initiating short positions in emerging markets is the way to go if one agrees with this viewpoint. A third option is to break down emerging markets into smaller groups and pick the one that is most likely to do well in the future. The group that is most likely to underperform is to be avoided or even shorted as an alternative or as an addition to long positions in emerging markets. How to differentiate between emerging markets While they may be grouped together under a single name, the fact remains that emerging markets are more often than not very different from one another. Some countries have little if anything in common with other emerging markets despite all of them being referred to as emerging markets. It may therefore be a good idea to think of emerging markets not as a single group, but rather as several distinct groups. There are many ways one could divide emerging markets into separate groups. For instance, some may be democratic countries, while others are more autocratic. Some rely heavily on the export of raw commodities, while others depend on the export of manufactured goods. There are lots of options if one wants to break down emerging markets into smaller groups. However, one way that should be given extra consideration is to divide countries based on whether they run a surplus or a deficit. More specifically, does a country run a current account surplus or a current account deficit and why should it matter? Why it matters whether countries have a current account surplus or deficit Countries with significant current account deficits tend to borrow heavily relative to the size of their economy, usually from foreign sources of capital. For many years, this wasn’t such a big issue due to the prevalence of very low interest rates in the U.S. This forced many to look at alternative places with higher yields. Many emerging markets offered such a destination. However, the Federal Reserve is widely expected to begin raising interest rates, which will make it more expensive to borrow. Monetary conditions have actually already tightened even though the policy of zero interest rates is technically not yet over. Capital outflows have picked up in a number of emerging markets as foreign capital is anticipating the next move by the Fed. In this environment where borrowing is increasingly problematic, countries with a current account surplus should be more resilient to higher interest rates than those with chronic deficits. The latter will have to make more adjustments to the existing structure of their economy than the former and this may cause a divergence in how countries perform going forward. Deficit countries do have a number of options when it comes to dealing with higher interest rates. For instance, they could try to reduce their imports and the need for hard currency to pay for these imports. Large reserves can also provide relief. Even so, surplus countries should have a much easier time as their transition period should be shorter and less complicated than those that have to fix or at least try to reduce their deficits. A major advantage for the former in comparison to the latter. Emerging markets ranked by surplus or deficit The table below lists 15 of the most prominent emerging markets, starting from those with the largest current account surplus to those with the biggest deficit. These countries combined make up 96.33 percent of EEM. Based on these numbers, Taiwan should have the least amount of trouble dealing with the Fed raising interest rates. South Africa is the one that looks the most vulnerable as of right now. Mexico may have a bigger deficit, but it’s also a bigger economy. Country GDP Current account surplus/deficit (USD) Taiwan 489B 19.67B South Korea 1410B 10.61B Russia 1861B 5.4B Thailand 374B 1.56B Malaysia 327B 1.21B Philippines 285B 0.95B China 10360B 0.63B Turkey 800B 0.09B Poland 548B -0.96B Chile 258B -2.59B Indonesia 889B -4.01B Brazil 2346B -4.17B India 2067B -6.2B South Africa 350B -8.68B Mexico 1283B -8.86B How to position yourself with regard to emerging markets One drawback of an ETF such as EEM is that it can get dragged down by a few bad apples. Some countries may do very well within the basket, but their performance can get negated by other countries that are doing poorly. A possible solution to this issue would be to take out the bad apples and leave only the good ones. If someone agrees with the thesis that emerging markets with big deficits will have a harder time with higher interest rates, then it’s best to avoid these countries and stick with the ones that run sizable surpluses. The latter are much less likely to experience any setbacks resulting from changes in global monetary policies. As such, they’re more likely to outperform resulting in better returns.