- Turkey's economic crisis and the slide in the lira has stoked fears of an emerging markets contagion.
- EM shocks are nothing new, or unexpected, though some recent factors need to be on the radar of investors: the strength of the U.S. dollar, tariff policy and years of emerging markets dollar-based borrowing.
- Long-term investors should be prepared to ride out volatility in emerging markets. Timing the market will likely result in even worse performance.
More investors, and many at younger ages, have come into the stock market as a result of the long run it has been on since the Great Recession ended. If they've done it right, diversifying equities around the globe is likely a part of their portfolio mix.
That means that whether they know it or not, they are likely to have some exposure to emerging markets. So it is time for them to know the answer to a few questions: Where does Turkey rank among countries in the MSCI Emerging Markets Index? And what does that mean for their stock market risk profile?
The two ETFs that have gathered the most in assets from investors in the past year are developed markets overseas and emerging markets stock funds: the iShares Core MSCI EAFE ETF (IEFA) and iShares Core MSCI Emerging Markets ETF (IEMG), with roughly $40 billion between them, according to XTF.com. These two ETFs also are No. 2 and No. 4 among all ETFs for investor dollars in the past three years, at roughly $87 billion.
Year-to-date, they've been No. 1 and No. 2 among all ETFs, with $28 billion in flows. There's some insider ETF baseball at work here: iShares launches these core ETFs at lower expense ratios than older, popular EAFE and EM ETFs (EFA and EEM), and so a lot of the money was migrating to cheaper ETFs rather than being brand-new overseas exposure. But there is a lot of individual investor money invested in overseas stocks, and investor assets were migrating because financial advisors are believers in long-term global diversification when it comes to stocks.
As Turkey's economic crisis persists and its currency, the lira, tanks, fears of a broader emerging markets contagion and a run on regional and European banks are understandably resulting in some investor panic. But pulling out of emerging markets indiscriminately would be the wrong move for many investors who are basing allocation decisions on decades of expected returns rather than focused on market trading, according to investing experts.
Investors who constructed investment portfolios for retirement or other long-term goals should understand that dumping everything would be the one response that contradicts the fundamental reason to invest in global stocks: Over longer periods of time, emerging markets stocks work, and that trajectory has not changed in the past few days.
Here are five keys for investors to understand long-term asset allocation during a period of global economic uncertainty.
So how much does Turkey represent in the MSCI Emerging Markets Index? Not much. It does not even register among 14 countries worthy of breaking out as a separate portfolio weighting, and is placed within the catch-all category of "other" country holdings, which represents less than 4 percent of the ETF in all.
Nick Colas, co-founder of DataTrek Research, points out that for Western investors, contagion is the issue, not Turkey itself. Turkish equities represent less than 1 percent of the MSCI Emerging Markets Index. Even with the country's equity market down by 51 percent in dollar terms since the start of 2018, that alone has little impact on diversified equity investors, Colas wrote in a research note on Monday.
The hit that emerging market equities have taken in the past few days, as the Turkish lira declined by double digits and Turkish equities in dollar terms broke through their 2008 lows, "shows how correlated EM equities can be during currency/economic crises, even when the country in question has a nominally low weighting," Colas noted.
China, South Korea and Taiwan have a collective 45 percent weighting in the MSCI EM Index.
Mitch Goldberg, president of investment advisory firm ClientFirst Strategy, said the popularity of ETFs is part of the reason why the volatility will spread across EM nations. "As far as overall sector, that is a big concern. Because of ETFs, all emerging markets trade together as a sector now. Whether it is a period of stress or a very bullish period, the assets are totally correlated to each other," he said.
In 2017 every stock market around the world was positive, and the term "synchronized global growth" was being thrown around as the only factor that mattered to the markets. That synchronicity works both ways.
"Can we finally get rid of the synchronized global growth fantasy?" Goldberg said. "Turkey is really just a symptom of the fact that too many emerging market governments and corporations borrowed massively in dollars and now face increasing cost-of-debt service due to weakening local currency."
Goldberg said investors need to stop looking at these incidences as if they're isolated, one-off events. There are commonalities developing that have to do with U.S. central bank tightening, a strengthening dollar, tariff policies and low-cost borrowing capacity and debt rollovers coming to an end.
"Escalation in trade tensions is hurting emerging markets the most. Rising interest rates in the U.S. and a strong dollar is adding to their woes. As a result, investors have been pulling money out of these countries this year. Further, synchronized global growth that had excited investors earlier is now running out of steam," said Neena Mishra, head of ETF research at Zacks Investment Research.
She noted that among major emerging market currencies, only the Mexican peso is up against the dollar this year, as investor confidence in the country has surged after its presidential election. There are a few emerging markets that continue higher: India's BSE Sensex is up more than 11 percent this year, and Saudi Arabia's Tadawul is also up more than 10 percent despite recent tensions with Canada.
But China's Shanghai Composite is down more than 15 percent this year, thanks to tariff fears, with its yuan currency down more than 5 percent. And since China gets more than 31 percent allocation in broad emerging market ETFs, it has hurt their performance much more than Turkey will. The iShares MSCI Turkey (TUR) ETF, which has a roughly one-quarter weighting to financials, fell more than 10 percent amid fears that banks in the region would suffer during the crisis.
Emerging markets is the most aggressive portion of most investor portfolios, so shocks should be expected, Goldberg said. And he thinks that any investor who expects to "get extra points" for picking the "right" emerging market in this environment will be proved wrong. Even the right one will go down, even if for the wrong reasons.
3. Emerging markets shocks and global contagion fears are nothing new and should not change a long-term game plan.
Three times during the 1990s emerging markets currency crashes led to broader fallout for the sector and world economy: Mexico (1994), Thailand (1997) and Russia (1998).
But more recent debt problems overseas during the current bull market have passed, though the biggest issues were in Europe. Remember the PIIGS? When Portugal, Italy, Ireland, Greece and Spain were going to sink the global markets in 2011? Maybe you forget, because they didn't.
"I'm paid to be disciplined," said Douglas Boneparth, president at financial advisory firm Bone Fide Wealth and a member of the CNBC Digital Financial Advisor Council. "The PIIGS are an example of when we expected a broader contagion, and this is the first time that EM has bitten investors," he said. "The current volatility doesn't get me depressed in any way," Boneparth added. Why? Because peak to trough, meaning the measurement of emerging markets performance from its highest highs to its lowest lows, makes one point to investors: Not including emerging markets in a portfolio is the mistake. "This is a great example of short-term thinking vs. long-term discipline," he said.
Younger investors with a 100 percent equities portfolio should have 10 percent in emerging markets equities and should maintain exposure. Even investors closer to retirement, with between a 40 percent and 60 percent equities weighting, should have an EM weighting of roughly 4 percent to 7 percent, Boneparth said.
"If you are a long-term global investor and a younger investor contributing systematically to a long-term portfolio, and dollar cost averaging in, what are you so worried about? Emotional investors make the worst decisions."
Mishra said investors that have any EM exposure should be prepared for more volatility, but most developing countries now have much better economic fundamentals, with sizable current account surpluses, strong forex reserves and well-regulated financial systems. "I don't think we'll witness a replay of the 1997 crisis," she said.
Ben Carlson, who manages portfolios for institutions and individuals at Ritholtz Wealth Management and writes the blog, A Wealth of Common Sense, has repeatedly made the point that looking at any short-term performance window can fool investors, and emerging markets are the perfect example.
"The 10-year annual returns on the MSCI Emerging Markets Index through the end of 2017 were just 1.7 percent. But the 15-year returns were 12.3 percent per year. How could this be the case? The returns from 2003–2007 were otherworldly, at 37 percent per year. This is an extreme example, but it shows how lumpy stock market returns can be. If you jumped in after those huge returns in the mid-2000s, you're feeling the pain. If you've been a long-term holder of EM, these past 10 years have been challenging, but the bull market returns that kicked things off have more than made up for the sideways market environment that's followed," Carlson wrote in an explanation for the "lumpy" return phenomenon.
Source: Morningstar, data as of 7/31/2018
"You can win any argument in the markets by simply changing your start and end dates," he wrote, and added, "Even the worst-case scenario from here isn't all that damaging to returns, assuming you can take the long view."
Most investors show very little ability to get into and out of markets at the right times, and an asset class as volatile as emerging markets only makes the potential for badly timed decisions greater.
Advisors say the right decision at a time like this is to look at asset allocations and rebalance as needed. With the gains in recent years from some overseas assets, it is possible that investors saw a target weighting in EM go above what they wanted for their risk tolerance. Selling to bring a weighting back down to its long-term target is a good decision and is not the same as indiscriminate selling.
"Don't throw away exposure to EM equities," Goldberg said. "This isn't the first or last time there will be a shock." But he added that people get caught with too much in emerging markets after a period of time when it has done well. "Don't get out, but make sure to rebalance as it becomes too big a portion of the portfolio."
Boneparth said if EM stock prices come down a lot, the right decision will be buying more to bring it back up to a target weighting. Investors should pair the long view on EM with a broader long-term view on investing.
The only question is whether the specific EM trade is a yes or a no, and the answer is still yes, Goldberg said.
"That's how you play any asset class, and EM seems to need more of the 'taking stairs up and escalator down' approach," Goldberg said. "It takes a long time to make money in them, and you can see it disappear quickly. Don't get out when things look bad or when things look good."
He said the overriding trend that makes emerging markets a strong long-term play hasn't changed: the billions of people entering middle class for the first time around the world. "If you look at the very long term, EM shocks are barely noticeable," Goldberg said.
Some of the most prominent investors of the 20 century, Vanguard Group founder Jack Bogle and Berkshire Hathaway chairman and CEO Warren Buffett, have repeatedly said investors do not need any stock holdings but the U.S. market. And they have used as their argument that U.S. companies have increasing exposure and revenue in emerging markets. That's a double-edged sword. It implies more U.S. stocks are at risk in any emerging markets crisis than investors may know. Other billionaires go to cash at the first sign of crisis to preserve the wealth they already have amassed. But for investors who need to be in the market long-term to be able to generate a financial cushion for later in life, the reasoning of financial advisors who believe that EM should be part of a long-term portfolio is more apt.
"Investors need to understand that long-term returns encompass both good and bad markets. This is an obvious statement but it's much easier to be a long-term buy and hold investor when things are going well," wrote Ritholtz's Carlson. "The hold part of the equation becomes much more challenging when markets don't go up in a straight line anymore."