How Low Can Emerging Markets Go?

Emerging-market (EM) stocks fell in the third quarter and continued to diverge sharply from developed-market equities. While it may be too soon to buy into the weakness, investors should watch for signs that could herald a quick rebound.

US, European and Japanese stocks have all advanced this year. But the MSCI Emerging Markets Index has tumbled in local-currency terms—and even more in US-dollar terms (Display below, left). EM returns have been dragged down by Turkey’s currency crisis and concerns that China’s challenges could be aggravated by the escalating trade war with the US. Investors are asking whether the sharp pullback since January will continue and are watching for signs of contagion to other markets.

After a two-year EM recovery, investors are fearful that a systemic crisis is imminent. We think it’s important to separate the issues and put the risks into perspective before withdrawing investments from EM stocks or allocating more to EM stocks in anticipation of a recovery.

Individual country performance provides a reminder that emerging markets aren’t all made of the same stuff. Turkish and Argentinian stocks were the worst EM performers this year, while markets in China and South Korea have also fallen. Russian and Thai stocks posted gains. In many markets, sharp declines in local-currency values led to much steeper losses in US-dollar terms (Display above, right).

Two Types of Problems, Two Types of Risks

There are two types of problems on the EM landscape today. First, there are countries mired in major economic and currency crises. Second, there is China.