Don’t Fear Emerging Markets
Emerging-market (EM) stocks have been under intense selling pressure most of this year.
In fact, while the S&P 500 finally hit a new record high this week, the MSCI Emerging Market Index remains 17% below its January high.
And it's not just EM stocks that are in the doghouse: EM currencies are also under fire.
The plunging Turkish lira has been widely reported, but it's not the only one. Currencies across the EM landscape from the South African rand to the Argentine peso have been falling off a cliff. Even fast-growing countries like India are under pressure, with the Indian rupee falling to an all-time low just this week.
Naturally, this currency carnage is stoking fears of a full-blown financial crisis, similar to the late 1990s.
It's easy to identify the culprit for the EM unwind, and it's an old familiar one: debt. As in too much U.S. dollar-denominated borrowing by EM countries in recent years. And we've seen this movie play out before, with an unhappy ending.
During the 1990s EM countries went on a borrowing binge, financing their economic growth with dollar-denominated loans. From 1990–2000, EM dollar-debts tripled in size to more than $2 trillion.
Of course that episode ended badly with a domino-effect currency devaluation by several emerging Asian nations in 1997–98. And this summer, we're seeing a rerun of the same plot.
Dollar-denominated debt reached a new record high of $11.5 trillion this year, according to the Bank for International Settlements (BIS). That's the highest level of indebtedness recorded during the 50-plus years the BIS has been tracking this data.
When times are good and EM currencies are stable or rising due to booming economies, borrowing helps fuel extra growth. But when the dollar strengthens, as it has this year, it's difficult for EM countries to pay back their dollar debts with a weaker currency. And that's when things begin to spiral down.
Turkey is just one of the more extreme examples, with nearly half its gross external debt denominated in U.S. dollars, but it has plenty of company: Argentina, Chile, Indonesia and even Mexico are also at high risk of crisis with too much dollar debt and currencies that have fallen hard against the buck (see chart above).
Interestingly, some EM stock markets have been dragged down with the rest, even though they are in much better shape to weather the storm. Both India and China, for example, have U.S. dollar debt equal to only 4% of their respective GDPs. Both nations also hold plenty of reserves to cover their dollar debt, so a strong dollar by itself shouldn't lead to financial crisis.
China's gross debt to other countries equals just 14% of GDP. While China owes nearly $550 billion in dollar debt, it also owns $3.2 trillion in foreign reserves, a big chunk of that in U.S. dollar-denominated Treasury securities.
Bottom line: Some emerging markets are better able to weather currency weakness and avoid a financial crisis, even though all stock markets in the space have sold off in tandem.
This creates a lucrative buying opportunity for savvy investors who don't fear to tread in emerging-market stocks.
Here's to growing your wealth,
Chief Income Expert, Mike Burnick’s Wealth Watch
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