While emerging markets are often grouped together, the reality is that they're not created equal. Since each country is different, it's only natural that some will have weaker fundamentals than others. As 2014 comes to an end, there are two global trends that look set to separate the strong from the weak among emerging markets.
The first is the strengthening US dollar with the prospect of higher interest rates. The dollar index has gained 10.53 percent over the last 12 months. The second is the decline in commodity prices as a whole and crude oil in particular. The Continuous Commodity Index is down 10.24 percent over the last 12 months.
The effect of lower commodity prices and higher interest rates on emerging markets
It's inevitable that there will be winners and losers among emerging markets with the decline in commodity prices. Those countries that rely on commodity exports will have less revenue and that will have a negative effect on the local economy.
On the other hand, those countries that import a lot of commodities will be able to pay less. That frees up money that can be used somewhere else, which in turn should help boost the economy. It offers the same benefits as a tax cut, but without the negative fiscal implications for the government.
At the same time, the Federal Reserve has ended Quantitative Easing (QE) and is widely expected to put an end to Zero Interest Rate Policy (ZIRP) by raising interest rates in 2015. If the Federal Reserve goes ahead and raises interest rates as planned, there will be much less need for carry trades that have provided many emerging markets with access to cheap capital.
Most emerging markets will face headwinds, but not all
Both of these developments have consequences for emerging markets. Most of these countries depend on commodity exports or rely on capital inflows to help with relatively weak fundamentals in their economy, such as funding large current account deficits.
When commodity prices are dropping and cheap global liquidity is coming to an end, this becomes a problem. Not only do countries have less revenue, but they also need to raise interest rates to stop the decline in their foreign currency reserves and the value of their currencies.
Looking at the BRICS, five of the most prominent emerging markets, three of them (Brazil, Russia and South Africa) rely heavily on commodities. A fourth one (India) has a growing current account deficit and needs a steady inflow of foreign funding to help manage its exchange rate. It's telling that the Indian rupee dropped in value when the Federal Reserve signaled its intent to reverse monetary policy in May 2013.
The election of a new government in India has lured back capital and temporarily halted the slide. However, if the new government fails to deliver on its promises, capital inflows could easily turn into capital outflows. Other emerging markets such as Indonesia and Turkey also face headwinds from either lower commodity prices or a stronger dollar.
China benefits from lower commodity prices and can deal with a strong dollar
One exception is China. While there are other emerging markets such as India that benefit from lower commodity prices, China is the biggest buyer of most commodities. It will therefore profit the most from a general decline in prices for commodities.
As an illustration, China imported 778 million tons of iron ore during the first ten months of 2014, an increase of 16.5 percent compared to last year. Yet despite these higher quantities, China was able to pay 5.4 percent less as the average price of iron ore declined by 19.8 percent.
Not surprisingly, China has posted record trade surpluses in recent months due to the fact that the amount it needs to pay for imports (which includes these commodities) has been reduced. It also helps keep inflation subdued, especially since the consumer price index (CPI) in China includes food and energy. All of this will boost growth in the economy.
At the same time, a stronger dollar benefits those with large reserves in dollars, but it's detrimental to those who have borrowed a lot in dollars. While many emerging markets fall into the latter category, China possesses large foreign currency reserves, which have effectively gained in value.
China is also much less vulnerable to the ebbs and flows of global capital. The country has a large current account surplus and does not need capital inflows to finance deficits unlike many other emerging markets. Furthermore, its closed capital account severely restricts the flow of capital in or out. While most currencies have weakened versus the dollar, the renminbi has managed to retain its value.
In short, an environment of a stronger dollar with higher interest rates and lower commodity prices favors China. Of all the emerging markets, China is in the best position to handle rising interest rates and take advantage of lower commodity prices. China is therefore likely to outperform other emerging markets thanks to its stronger position.
Long China and short emerging markets
Despite having fewer headwinds and more tailwinds, China still trades at a discount versus most emerging markets. For instance, the MSCI Emerging Markets Index has a price-to-earnings (P/E) ratio of about 13 and the MSCI China Index has a P/E ratio of about 9. China is cheaper for now, but that discount relative to other emerging markets will not last as long as commodity prices stay low and interest rates go up.
Assuming that China is set to outperform other emerging markets and we would like to hedge our position whether the market goes up or down, then long China and short emerging markets fits the bill. If emerging markets rise, China should rise faster and if emerging markets fall, China should fall less.
ETFs dedicated to emerging markets and China include EEM (NYSEARCA:EEM), VWO (NYSEARCA:VWO) and FXI (NYSEARCA:FXI). The bottom line is that China's trend is up, while the trend for emerging markets is down.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.