The Federal Reserve has increased interest rates seven times in the past three years

    The Federal Reserve has increased interest rates seven times in the past three years

    Has the tide turned on emerging markets?

    6 October 2018

    This year has been bad for investors in emerging markets. The MSCI index has dropped around 20 per cent since January — the definition of a bear market. Does that mean it’s time to get in ready for an emerging markets rebound? Or to remember the widely used stock market adage about not trying to catch a falling knife?

    Turkey had an attempted military coup, then a vicious political crackdown. China is slowing although no one knows by how much (the official data is questionable). Venezuela is experiencing inflation at more than 80,000 per cent after its ‘failed socialist experiment’. Argentina has been an economic disaster for years.

    There are many reasons for investors to shun emerging markets: over-indebtedness, weak commodity prices (emerging economies tend to be exporters of commodities), political failures, corruption and instability to name a few. However, there is a problem that affects them all: significant debt denominated in dollars which is getting more expensive to repay.

    The Federal Reserve has increased interest rates seven times in the past three years from the low of 0.25 per cent to 2 per cent currently, making borrowing in dollars more expensive. That has led to a stronger dollar, ensuring it is more expensive to repay dollar debt in, say, Turkish lira from Turkish tax receipts.

    Moreover, as global investors are paid higher interest rates to lend to the US government, they no longer feel the need to lend to emerging countries to get a decent return. The cheap US money tap, in other words, is being turned off. Recognising that, emerging market currencies have weakened. And that makes the situation worse. Turkey is a good example. A few weeks ago its central bank (fighting off political interference from President Erdogan) had to raise interest rates by a full six percentage points to 24 per cent to prop up a Turkish lira that is down 40 per cent against the dollar year to date. Inflation has rocketed to 18 per cent and the economy is near a standstill.

    Worse, tighter US monetary policy is set to continue. Donald Trump is engineering an economic boom with $1 trillion of unfunded tax cuts at a late stage in the cycle. Higher interest rates and a stronger dollar are the likely result. On top of this, the US president is also embarking on a trade war with China. Other emerging market economies (Asia in particular) are likely to suffer in the crossfire.

    However, the long-term investment case for emerging markets has not changed. GDP is set to grow faster than the developed world, driven by increased urbanisation, productivity gains and growing populations. It’s one of the reasons former Goldman Sachs partner Jim O’Neill has long been so keen on the BRIC economies.

    It is possible to look on the bright side. Although US interest rates are going up, they are still very low and are likely to peak below previous cyclical highs. While it is true that emerging market economies are indebted, so are developed countries. Ukraine, for example, has a lower debt to GDP ratio than the eurozone. Japan’s debt to GDP is over 250 per cent while India’s is 70 per cent.

    What do I do with my own money? I am a long-term investor. I do not believe in timing markets — trying to buy when cheap and sell when expensive. I buy and hold and I reinvest the dividends. My money is in the Vanguard LifeStrategy 80% Equity Fund. I am happy to take risk as my time horizon is decades — hence I have 80 per cent in equities. It is a passive fund which invests globally, benefitting from a wide choice of companies in which to invest. One of its attractions is low cost — fees can take away a huge chunk of your savings pile.

    Looking up where my money is invested, 24 per cent of the fund is in the UK, 40 per cent in North America, 14 per cent in Europe, and 7 per cent in Japan. Adding that up means that 86 per cent of the fund is in developed markets. So, 14 per cent is invested in various emerging markets: Eastern Europe, Central and South Africa, Middle East and Africa and Asia Pacific. That sounds right to me. I want some exposure but not too much, given the risks.

    The investments are mostly unhedged, which means my fund will be down thanks to the emerging market stock market falls as well as the currency declines. But I am OK with that. Some markets go up, some markets go down, but that is not a problem if your money is invested in diversified places.

    Warren Buffett said: ‘Be greedy when all else are fearful. And be fearful when all else are greedy.’ The emerging markets fear is relatively widespread — the World Bank and the IMF have warned about them recently. But if you fancy doing what I don’t and ‘timing the market’, there may be buying opportunities in the months to come.