Let's begin by looking at what has happened in EM currency recently via a set of charts. Everything began with the Turkish Lira in early August.
Both countries have experienced nearly 50% currency devaluations this year. This means that all import prices have essentially doubled - whether oil, metals, other commodities or finished goods.
What these two countries have in common are large current account deficits: a large amount of borrowing financed by dollar (or Euro) denominated loans, as well as lesser in-flows of FDI (foreign direct investment) and hot-money equity capital. Of these flows, FDI is usually the good kind of investment, as it is usually used for productive investments chosen by the owners of that capital, and it is usually patient, long-term capital. Loans can be in this category, but due to the global hunt for yield that has occurred since the end of the financial crisis, many articles have pointed out that lenders have become less picky about covenants and who they are lending to. USD or EUR denominated loans in particular are quite problematic leading into crises because the income by which they are serviced comes in the local currency while the obligations are in a different currency. In a long period of stable exchange rates, they can be useful, leading to lower borrowing rates than are available in local debt markets, but when these periods end, they inevitably lead to elevated default rates and severe recessions.
Knowing this connection between current account deficits and currency crises, what can we expect to see if we look at currencies with slightly less bad deficits? The next three charts look at Russia, Brazil and South Africa.
South African Rand
While none of these countries has entered the realm of a currency crisis, they are clearly experiencing headwinds that would affect their economies. Generally, the combined impact on stock returns can be seen by looking at the performance of EEM against the S&P.
Next, we enlarge our view a bit and take a look at some of these countries in a global context; all current account balances listed in the table below are given as a percent of that country's GDP (so the EU, Chinese and US amounts are quite large in absolute terms).
We can see that among notable markets, China is a net exporter of capital (positive current account) to the tune of 1-2% of its GDP while India and Indonesia import capital in relatively small amounts. The EU is the largest exporter of capital as a group. The US is a largest absolute importer of capital due to the high GDP multiplying the 2-3% current deficit number.
One less-used valuation measure is the Fed's flow of funds based Tobin's Q.
This metric excludes financials and looks at the ratio between the market value of equities and their replacement values. Periods when it has been below 0.8 are when the equity market was particularly cheap and subsequent performance has been fantastic; periods when it was 1.2 or higher have not been good for subsequent 5-10 year equity market returns. The last time the measure was this high was in 1999 (we should note that how much US corporations manufacture or sell abroad has no impact on this metric, which is a valid criticism of using the market cap to GDP ratio as a valuation metric in a time of rising non-US manufacturing and sales).
Many value investors use market cap to GDP or Shiller PE-based valuation models to infer projected annual returns over the next 10-years. These models assume that over this time horizon, valuations will revert to the long-term mean for each market. Based on this methodology, the next chart shows relative rich/cheap levels across a number of countries.
Given high valuations and low projected long-term returns for the US as a whole, what is an appropriate non-US allocation for a US-based investor to choose to re-balance to at this point in time? While it is tempting to apply the "buy-the-dip" methodology or to "buy what is cheap and sell what is rich", using EM ETFs is probably not the best approach. Turkey and Argentina face several quarters of increasing corporate defaults due to their currency crises; these could result in prolonged recessions.
There is considerable uncertainty in how far and wide this contagion will spread. In worse scenarios, the risk aversion could easily spread to other non-investment grade borrowers, as banks suffering losses on Turkish, Argentine, South African, Russian or Brazilian loans reduce their risk appetite by not renewing lending lines to more speculative European and American corporations. This not only increases the risk for other emerging markets but for the junk bond sector as a whole, especially if there is any slow-down in sales or profit growth over the next few quarters, as the benefits of US Tax Cuts have been "fully priced in" and future comparisons are to this higher base level of profits. Additional risks come from the mid-term elections, and the potential for fiscal tightening if a "Blue Wave" election occurs as current forecasts appear to indicate.
Quality & Value
We believe that the solution is to look for both quality and value. Quality refers to countries with solid financial fundamentals, such as a positive current account, reasonable government borrowing and hence stable currencies. Quality in corporations refers to relatively low leverage and business models that produce stable and rising revenue with profits. At a time of potentially great turmoil in trade tariffs, quality would also suggest buying more domestically focused companies in countries with large or growing middle classes, such as China and India.
To the extent that both value and quality can be purchased, we believe the time is soon approaching. China has been flirting with bear market territory for much of this year. Meanwhile, several articles and interviews have discussed the role that China's local markets will play in MSCI indices going forward, after an underwhelming response to the first inclusion of "A-shares" from China in May.
"Round Two of MSCI China Addition Is Bigger Deal for Global Funds" (Bloomberg)
"Why China's First Steps Into MSCI Are Such a Big Deal" (QuickTake)
( Noted International Investor) "Mark Mobius Says MSCI Inclusion to Have Substantial Impact on China Stocks" <video>
"China will replace Japan as the single largest country constituent in the Asia-Pacific region by 2023" (Nomura Research Note June 1)
While the inclusion impact is to be felt via MSCI indices, it is not the case that ETF flows are the primary reason for the index inclusion to have an impact. Rather, it is that so many active managers compare their fund performance to MSCI indices on their websites and marketing material, as well as internal performance evaluation and compensation determination.
Likewise, we do not recommend the use of ETFs for EM exposure management, even at a granular level using country-specific ETFs. We illustrate the value of paying an expert to manage both company-specific relative value and country exposure using the following graph going back to 2009.
MAPIX is the Matthews Asia Dividend Fund; while it charges a fair amount more in management fees than a low-cost ETF such as EEM, we can see that the Asia-Pacific region (the MSCI benchmark for this fund) has outperformed the EEM ETF by over 3% a year (4.25% vs 7.4% annualized), while the fund itself has outperformed its benchmark index by over 2.6% (10.03% vs 7.4%).
Based on the relative value analysis across countries and the troubling over-valuation of the US market as a whole, we believe that over the next 5-10 years, MAPIX is quite likely to outperform the S&P500 as a whole. While timing entry at times of market stress is always tricky and can be stressful, simple dollar-cost averaging approaches and automatic investments can make this a relatively simple process. We would advise readers to examine their optimal allocation to US equities (reading up on the Vanguard site is a good start) as it may be a good time to start to take "bubbly" profits and reallocate a good amount to cheaper assets.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.