Written by: Lauren Goodwin, CFA There is no denying that emerging markets have had a difficult year. Investor sentiment towards EMs has deteriorated, EM currencies have weakened by 10-15% across the EM complex, and falling equity prices have added to the misery. 
While redemptions out of EMs have been heavy, there are reasons to believe that the EM complex is oversold. For starters, most countries’ economic fundamentals have not materially weakened leading up to or through the selloff. While portfolio outflows have been meaningful, capital outflows – business investment in on-the-ground economic capacity – have been well within normal ranges. One reason for this is that multinational corporations are accustomed to currency and market volatility in less-developed countries and tend to take a “wait and see” approach to their business rather than abruptly change their international investment plans.What’s more, price divergence between U.S. and emerging market equities is extreme. The 65-day performance spread between the S&P 500 Index and the MSCI Emerging Markets Index is flirting with the 5 th percentile of all historical observations, suggesting that some mean reversion is likely.At this time, we consider it unlikely that emerging markets issues will worsen substantially or propagate to the global financial system.Related: Seeking Growth in a Changing World by Staying Active Related: Smooth Out Market Volatility With a Merger Arbitrage ETF
Substantial short-term risks remain
Still, the global economic dynamics driving portfolio outflows have worsened
since we last posted on the topic. Indeed, trade protectionism has increased since the summer, as conciliatory tones with Europe, South Korea, and North America have been matched by the Trump Administration’s demonstrated willingness to impose additional tariffs on China. Trade measures would have to worsen (e.g. higher tariffs) and stay in effect for an extended period to materially impact global economic growth, but this remains a distinct possibility. Adding to this dynamic is the fact that China’s economic growth – which is already experiencing a managed slowdown – is intrinsically tied to the success of other emerging markets economies, notably through commodities exports. If China sneezes, then other emerging markets are more likely to catch a cold.Central banks shifting from quantitative easing to quantitative tightening is redirecting capital flows and driving up debt capital costs within the EM complex. In addition, the dollar has remained strong relative to emerging markets currencies, which can be problematic for countries with significant external financing needs or large dollar-denominated debt balances. To add a fourth complicated factor, oil prices have risen, which can stabilize government coffers for energy exporting economies, but worsen external liabilities for energy importers – namely Argentina and Turkey.
Investment implications
The past couple of weeks have reinforced that markets can sell off even when economic fundamentals are positive. Business activity and earnings are strong, but prices take expectations for growth into account, and global growth is likely to be lower in the future than it has been in the past 12-18 months. Despite our high conviction belief that emerging market equities will perform well over an extended period, we are only modestly overweight emerging markets economies at present, less so than earlier in the year, as we are mindful of the potential for protectionism to yet inflict material harm.The interconnected contributors to global portfolio and capital flows will continue to obscure the emerging markets story. Relative economic performance across countries and currency dynamics will play a particularly strong role and are difficult to time. Investors should seek alpha exposure in emerging markets, not beta exposure. Active management thus remains a prudent consideration across the emerging markets complex.
