As the Federal Reserve gets set to end its massive multi-year stimulus program, emerging markets are shuddering. That's because the possibility of imminent Fed "tapering" is leading many investors to yank their money out of emerging-market stocks and bonds and placing them in higher-yielding U.S. bonds.
I recently wrote about the burgeoning appeal of emerging-market stocks, which are currently in turmoil but starting to look like deep value plays for long-term investors. Still, until these markets settle down and form a bottom, it's wiser to nibble than go whole hog.
Yet when it comes to emerging-market bonds, there is a different set of factors to consider. They are interrelated and can help determine which bonds are safe -- and which are potentially toxic. Those three factors: trade balances, foreign currency reserves and currency changes. Let's take a closer look.
Surplus Or Deficit?
A nation's trade balance is likely the single most important item you need to track as you assess emerging markets. A nation that runs a strong trade surplus is likely to retain a firm currency over a multi-year period. And countries that run trade deficits are extremely vulnerable, as they depend on global capital to help keep their economy and currency from collapsing.
For instance, India, which runs stubbornly large trade deficits, is currently seeing a massive run on both the rupee and its stock and bond markets. Global investors have already assumed that the Indian economy is headed for very tough times as capital grows scarce.
Looking at the 60 largest economies in the world, here's a look at the emerging-market countries running the largest trade deficits. (The U.S. is included for context.) Though the U.S. runs huge trade deficits, the global appeal of the U.S. dollar means we don't have to worry about trade balances wrecking our economy -- at least for now. A number of European countries also run trade deficits in excess of $30 billion, which is still much lower than the U.S. deficit as a percentage of GDP.
Large Trade Deficits
Sources: CIA World Factbook, United Nations
Note that many emerging-market economies have been home to some of the most dynamic growth rates in the past decade. It's increasingly clear that a high reliance on imports played a key role in that growth, and these countries must figure out ways to reduce imports and boost exports. (Those can be accomplished through currency weakness, which I'll note in a moment).
But what about economies that have been running trade surpluses? Although China leads the pack, with a $214 billion trade surplus in 2012, several Asian countries -- including Singapore, Taiwan, Hong Kong, Malaysia and South Korea -- show healthy trade balances. The key takeaway: Bonds from these countries have little to fear from the chaos caused by the Fed's moves.
So are emerging markets set for the same kind of meltdown we saw 15 years ago when the Thai baht and Russian ruble collapsed, leading to a global scare? That's quite unlikely, for the simple reason that many countries now hold a solid amount of foreign currency reserves, which can be used to shore up a currency if a crisis emerges.
Back in 1998, many central banks were not yet fully aware of the need to keep a sizable amount of foreign currency in the vaults. Here are the foreign currency reserves, as a percentage of their GDP, in the leading emerging economies.
Foreign Currency Reserves
Sources: CIA, U.N.
Here again, Asian nations heavily populate the list. It is notable that Brazil and India also maintain sizable amounts of foreign currency reserves, though global investors are likely concerned that those reserves are starting to erode as foreign direct investment (FDI) starts to wane in those countries.
The Currency Factor
Trade balances and foreign reserves need to also be viewed in the context of currency changes. In the past three to four months, Indonesia, India, Brazil, Australia and many others have seen their currencies rapidly weaken. As this article from Bloomberg notes a basket of key currencies, all of which had been rising in 2011 and 2012, have fallen all the way back to 2010 levels.
These currency moves are causing deep short-term pain, but they might be setting up profound long-term gains. In the near term, a weaker currency for any nation that runs trade deficits means that import prices are rising, and an upward move in inflation can lead central banks to raise interest rates to reverse the trend. That's a major negative for Brazil right now and could also become a trend in Indonesia, Turkey, India and elsewhere.
Yet over the long haul, weaker currencies boost the relative appeal of exports, and can lead to domestic displacement of imports. Countries like Brazil, Indonesia and Turkey are blessed with favorable demographics and sit among sizable regional trade blocs. But it's crucial that their economies expand to the point where domestic consumption can be met by domestic manufacturing output. A weaker currency helps.
Risks to Consider: We may not have seen the end of the emerging-market rout, which makes this a great time to brush up on these issues and proceed only when countries show relative health in terms of trade balances and foreign currency reserves.
Action to Take --> Across emerging markets, Asia remains as a notable bright spot, especially as fears of a deeper economic slowdown in China are starting to fade. That makes emerging-market bond ETFs increasingly appealing, as they are being sold off in tandem with truly vulnerable bonds issued elsewhere. The WisdomTree Asia Local Debt ETF (NYSE: ALD), for example, is touching 52-week lows after falling 10% since early May. The fund invests in "fixed-income securities issued by Asia ex-Japan governments, agencies and corporations denominated in the local currency," according to the ETF's prospectus.
Investors may also want to check out the SPDR Barclays Capital EM Local Bond ETF (Nasdaq: EBND). This isn't a pure play on Asia, as top bond holdings are held from Mexico (12% of the bond portfolio), Poland (9%), South Korea (8%), Malaysia (8%), Thailand (8%) and the Czech Republic (7%). Yet as these are government-issued bonds, backed by countries with solid foreign reserves, the default risk is minimal. And the current yield, which has moved above 5%, is hard to beat.
Though bonds likely hold a greater level of safety than stocks right now, top companies in leading emerging markets are becoming compelling bargains as well. Many of these companies focus on developed markets and have shown a lot of resiliency in the past. I recently discussed the appeal of the iShares MSCI Emerging Markets ETF (NYSE: EEM) and still think that its blue-chip portfolio is gong unappreciated by global investors.