Pundits Predicting Panic in Emerging Markets
- With EM stock prices plummeting and investors fleeing EM funds, the fear of emerging markets is palpable. Our examination of three key metrics—external debt, foreign exchange reserves, and current account balance—shows, however, that EM countries have low risk of a broad funding crisis.
- EM stocks are comparatively cheap when measured by CAPE, price-to-book ratio, price-to-sales ratio, market cap to GDP, and other metrics. Now, when fear reigns supreme, it’s time to buy, not sell.
“The overall shape EM countries are in has a lot more cracks now than it did five years ago and certainly at the time of the global financial crisis.”—Carmen Reinhart
“It’s become at least possible to envision a classic 1997-8 style self-reinforcing crisis: EM currency falls, causing corporate debt to blow up, causing stress on the economy, causing further fall in the currency.” —Paul Krugman
Before its $50 billion bailout by the International Monetary Fund agreed to in June, Argentina had raised short-term rates to 40%! In May, Turkey raised rates by 300 basis points (bps) as the lira fell to fresh lows. At the same time, emerging markets (EM) stock prices have been plummeting. Since the peak on January 25, 2018, through June 15, 2018, EM stocks are down 11 percentage points and retail investors are fleeing EM funds. In May, net EM outflows totaled $12 billion.
We feel the fear. To decide if we ought to abandon our EM equity positions, we examine the risk of a broad EM funding crisis with our frontal cortex rather than with our limbic system. Is the panic peddled by pundits today justified? We think not, for several reasons: First, the global economy has become more stable. Second, EM countries have become wealthier and financially healthier. Third, countries that are under threat, and thus making headlines, compose only a small fraction of the value of EM equity markets. Fourth, the relative valuation of EM stock markets is discounting quite a bit of bad news, especially relative to the valuations of US stocks. And fifth, the instinctive reaction to a 10% correction in the US market is to “buy the dip,” while the instinctive reaction to a similar decline in EM is contagious fear.