Emerging markets are well-known for their volatility compared to developed markets like the United States or Europe. While some risks are difficult to predict, four significant factors are affecting emerging markets on an aggregate basis. Understanding these factors can help international investors avoid dicey situations and predict the long-term movements of emerging markets relative to other asset classes.
Four Drivers Affecting Emerging Markets
We will look at the four major factors affecting emerging market performance and what they mean for international investors:
Developed Market Demand
Many emerging market countries manufacture products and/or sell services to developed market economies. For instance, China makes all kinds of goods for the United States and Europe, while India has become a leading exporter of information technology services. A downturn in developed economies can, therefore, have a negative impact on emerging markets that rely on demand to bolster their economic growth.
After the 2008 financial crisis, many developed countries have struggled to return to normal growth rates. But, things are finally turning around. The International Monetary Fund projects that global nominal gross domestic product (“GDP”) will exceed 5 percent in 2017, which represents the strongest growth rates since 2011. This could mark an end to years of weak developed country growth and could become a turning point for emerging market performance.
Domestic Economy Performance
Many emerging market countries are driven by domestic demand rather than export demand. For example, exports account for just $260 billion of India’s $2.45 trillion (nominal) economy — or about 10 percent of its total economic output. By comparison, China’s $2.3 trillion in exports account for more than 20 percent of its $11.8 trillion (nominal) economy. Domestic factors — like consumption and politics — have a big influence on these emerging markets.
Often times, emerging market economies evolve from an export-driven economy to a domestic-focused economy. China’s transition has taken growth rates from more than 12 percent per year in 2010 to less than 7 percent by 2017. The upshot is that domestically-powered economic growth is widely viewed as more stable than export-driven growth since it doesn’t depend on external factors. And, China’s economy is finally stabilizing at these levels.
Currency Market Dynamics
Many emerging market countries have unstable local currencies and must issue debt in dollar-denominated bonds. When the U.S. dollar rises, these debts may become costlier to service for emerging markets that earn revenue in local currency. A higher dollar valuation also implies higher interest rates, which tend to draw capital away from emerging markets and makes it more expensive for emerging markets to raise future capital.
Since 2011, the U.S. dollar has experienced a strong rebound that has been a drag on emerging market performance. The good news is that these trends have started to moderate moving into mid-2017 — a move that could help boost some emerging market equities. Of course, the currency markets tend to be unpredictable in the short-term, and rising U.S. interest rates could lead to a further rally if hikes take place faster than anticipated.
Many emerging market countries are net exporters of commodities, which makes them sensitive to changes in commodity prices. For example, Russia is a large exporter of natural gas to Europe and Brazil exports iron-ore, soybeans, coffee, and crude oil to China and the United States. A downturn in these commodities could have a dramatic impact on the revenue generated by state-owned and private enterprises in these countries.
Commodity prices have dramatically fallen since 2011 due to slower end-market demand, but the global economic recovery is slowly boosting demand. Since 2016, metal commodities have experienced a significant rebound that has helped many emerging markets. Copper and palladium prices have been strong performers during the first half of 2017, which has helped offset weakness in crude oil and natural gas prices.
Consider Investing in Emerging Markets
Emerging markets are a great way to diversify any portfolio and understanding the underlying performance drivers can help time the market. International investors holding emerging markets have certainly felt the impact of their underperformance since 2011, but these trends could be turning around as long as the U.S. economy remains on track. Those without emerging market holdings may want to consider adding the asset class as these trends play out.
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