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Fed move could add pain to emerging-markets hangover

Michael Santoli
Michael Santoli

Like many things that are good for us in the long term, spreading investments across all corners of the world means tough sacrifices and moments of doubt.

Owning emerging-markets stocks in a diversified portfolio has been painful in recent years, especially for a U.S. investor who earns and spends in strengthening dollars.

The main emerging-markets ETF, iShares MSCI Emerging Markets (EEM), is trading at a four-year low. U.S. stocks, by some measures, are at a 10-year high relative to emerging equities.

To cite one dramatic example, Brazil, as tracked by the iShares MSCI Brazil Capped ETF (EWZ), is down more than 40% in dollar terms in the past year, giving back nearly all of the prior decade’s gains.

An investor in developing economies right now is effectively fighting the Fed - and fighting all the global forces that are driving the Fed to begin pushing interest rates higher before too long.

U.S. growth is relatively strong. So tighter money is likely on the way. So the dollar strengthens. This drains capital from developing economies, pressures the price of commodities that many of them rely on, and makes bad growth rates worse.

China’s market is, of course, in sharpest focus as these trends unfold. But even Australia – a commodity-reliant economy that bridges the West and emerging Asia – is enduring a rough time, as seen in the drop in the iShares MSCI Australia fund (EWA).

The unrelenting stress on emerging economies has prompted questions about whether Fed Chair Janet Yellen will be more hesitant to boost rates - even with a firm U.S. job market - given the possible market flare-ups it could cause in Asia, Latin America and elsewhere.

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Fed officials routinely insist they watch everything, but their mandate on American jobs and inflation dictate policy.

So if the domestic conditions finally cooperate and our markets are not in mid-tantrum, so-called rate liftoff can and will happen. But the fragility of global markets is just one reason Yellen will probably move very slowly in “normalizing” rates even once she gets started.

Where does this leave an investor who’s trying to follow the standard wisdom of sticking with a broadly varied array of investments?

Well, emerging-market stocks are fairly cheap, based on cues such as corporate book value and dividend yields. But they’ve looked cheap for a couple of years now, especially compared to premium-priced American stocks. That’s sort of reassuring for the long term but doesn’t help to time any real rebound.

Maybe no stock reflects the challenged state of EM economies more than Brazil’s state-steered energy giant Petrobras (PBR) –at the center of all the growth, commodity and currency worries dogging emerging markets.

The stock is down 60% the past year and 80% from five years ago. It has towering debt levels, and last night reported an 89% collapse in profits and an unexpected asset writedown.

Watch how the stock trades in the coming days for a clue about whether the market is beginning, tentatively, to decide that most of the nastiness is known and past.

Note, too, that the history of EM stock performance following a first Fed rate hike has not been universally poor in prior cycles, according to JP Morgan Asset Management research.

There’s some hope among careful observers that - even if the long hangover from the emerging-market and commodities binge of a decade ago drags on longer - it doesn’t have to result in the kinds of crashes and currency crises we got used to in prior cycles.

We can all hope that’s true. Even if we need to understand that – popular myth aside – Janet Yellen is not central banker to the entire world.