Explaining the Pain in Emerging Markets

Trading floor at the Philippine Stock Exchange in Manila, Philippines on May 17 Photograph by Bullit Marquez/AP Images

It’s been a tough summer for emerging markets, amid a year that has cut more than $1 trillion from the value of their stock markets. Currencies and bourses in India, Indonesia, and the Philippines keep getting hammered. Here’s what emerging-markets gurus are saying about the situation.

Arjun Jayaraman of Causeway Capital Management says that fears of rising interest rates in the U.S. are behind the selloff. He says the carry trade of borrowing in U.S. dollars and lending in higher-rate currencies in emerging markets provided essential support for those economies since the financial crisis. “Then, at the slightest hint that U.S. rates are going up,” he says, “we have seen a tremendous unwinding of that trade. Unfortunately, this is a situation that feeds on itself as very few buyers of emerging-market currencies emerge due to the risk of the trade. You can lose an entire year’s worth of carry in one or two days of negative currency movements.”

Charles de Vaulx of International Value Advisers says the “problems are the result of loose monetary policies in the U.S. and other countries (like U.K., Switzerland, and now Japan) that have created mini credit bubbles in many emerging countries. Inflation and misallocation of capitation has resulted from that.” He also cites China’s slowdown and a growing realization that many emerging-market stocks, such as Samsung and PetroChina, are plays on the global economy—not on local growth.

Even if emerging economies were prime beneficiaries of U.S. monetary largesse, their weakening growth and falling currencies could now hurt the U.S. economic recovery. “Longer-term we should care, due to the feedback loop to the U.S.,” Mohamed El-Erian, chief executive officer and co-chief investment officer of Pimco, the world’s biggest manager of bond funds, said in a radio interview today on Bloomberg Surveillance with Tom Keene. “You will see a tightening of financial conditions to markets. You will see growth more challenged, and the ability of U.S. companies to get top-line growth from emerging markets is going to be less going forward.”

Now throw in worries about an attack on Syria and a broader destabilizing of the Middle East—the likes of which have already sent West Texas Intermediate crude oil prices to a two-year high. Brent crude may “spike briefly” to $150 a barrel if a U.S.-led attack on Syria sparks further conflict in the Middle East and leads to supply disruptions, Société Générale said in a Wednesday report.

While Syria itself isn’t a major oil producer, its ally Iran is: One-fifth of global supply gets transported through the Strait of Hormuz. A spillover of instability into the Suez Canal or Syria neighbors Iraq and Turkey are also of concern. Higher prices are disproportionately painful for key emerging markets that are net importers of the commodity, such as India, Indonesia, Turkey, and Thailand—particularly as they grapple with weakening currencies.

Causeway’s Jayaraman says the prospect of war or military action has increased global uncertainty and led to the selloff of risky assets such as emerging markets. “We do understand why some markets such as Turkey and the Middle East have sold off due to their proximity to the conflict,” he says. “But the broader-based emerging-market selloff, as it relates to Syria, seems unwarranted.”

Ed Yardeni of Yardeni Research says that fears of the Fed, Syria, and crude oil prices only partially explain emerging markets’ swoon. He calculated that the projected earnings of the companies in the MSCI Emerging Markets composite index peaked at a record high two years ago and has been trending lower ever since. Analysts’ consensus estimates for both 2013 and 2014 also are falling, and at a faster pace in recent weeks. And net earnings revisions have been negative for the past 30 months. Yardeni says “the big story” is the collapse of emerging markets’ projected profit margins, to 6.5 percent from around 8.5 percent since early 2011—likely due to rising labor costs and a recent increase in oil prices.

For all the attention placed on threats, Mark Mobius, a longtime emerging-markets cheerleader, would rather focus on how developing economies are still forecast to grow about five times faster than developed markets in 2013. He likes how emerging markets generally have large and growing foreign exchange reserves and debt levels relative to their gross domestic product typically much lower than that of many developed markets. “There are always risks, and unexpected shocks could occur,” he writes. “But I still believe in the comeback story.”