The challenges Emerging Markets face, then and now

In the late 1980’s when I started my career, ‘EM’ was a new term and MSCI had just created its first emerging markets indices. EM has since experienced exponential growth, fueled by international sponsorships, an abundance of EM resources and capital markets innovation.

During this period of growth, markets weathered many harrowing moments of risk, including the 1989 Brady Plan, the 1997 Asian financial crisis and then Russia’s default on domestic debt. Some countries appear to be in perpetual crisis, including Argentina, which is on the brink of its third default since 2001. I can cite endless risk events, but in the end most have led to financial innovation and opportunities for investors.

Certain macroeconomic variables have repeated over time and consistently left traces that provide a roadmap for investing in emerging markets. Indebted countries often seek financing in major international currencies to build global reserves for essential imports such as food, fuel and medicines, while tapping into a larger dollar investor base with access to longer debt maturities. As the cost of borrowing rises and exchange rates suffer relative to their indebtedness, balance sheet stress at the sovereign level is amplified.

This can lead to national bankruptcies, leadership challenges and social unrest. The implications for the private sector can be severe, leaving creditors with complicated portfolio complications.

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Looking at the world today through the lens of past experience with emerging markets, there is a perfect storm brewing for indebted countries with undiversified economies, fueled by a broader crisis of confidence in global markets.

The US is experiencing its highest inflation in 40 years and very few have managed investments in situations akin to today’s inflationary environment, not to mention the disruptive liquidity implications of over a decade of quantitative easing experimentation is now withdrawn.

Aggressive, albeit reasonable in our view, action by the Federal Reserve and other developed market central banks has led to US dollar strength.

Meanwhile, emerging markets are fighting their own inflation battles, facing weaker currencies and ever-higher interest payments. Sri Lanka, Ecuador and El Salvador are currently experiencing social unrest and government changes with rising interest payments and the inability to import food, fuel and medicines, similar to the challenges Mexico, Argentina and Russia experienced in the 1980s and 1990s.

For most of the 21st century, historically low interest rates in developed markets helped propel emerging markets by providing the means to manage debt obligations. Meanwhile, strong restraints on fossil fuel investments and the conflict in Ukraine have pushed up food and energy prices.

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Today’s volatile market environment, plagued by higher interest rates, higher inflation and elevated default rates, could last longer than previous cycles.

I don’t think passively buying the dip is an effective investment strategy. More than ever, bottom-up analysis is the most effective approach to surviving these markets – credit, legal and investigative work are vital.

Investors need to fully understand the local complexities in each country to invest well, but also have the tools to ensure a profitable exit. There are thousands of investment situations in emerging markets in diversified economies. Many private sector companies are less leveraged than their developed market peers and produce basic necessities.

From my experience, liquidity and capital flows in emerging markets often work against passive investors. The EM asset class is often “discovered” by money managers and receives “tourist flows” in search of a new source of alpha for a diversified portfolio.

In fact, investors end up buying the beta of the asset class when markets are stable. Market liquidity is almost always temporary, but this tends to be even more the case in emerging markets. When the market cycle inevitably turns down, the combination of limited liquidity and the reversal of tourist flows can amplify asset price volatility in emerging markets.

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Now more than ever, active management in emerging markets has to start at the bottom. It is paramount to understand how companies have weathered previous storm cycles.

Better yet, find companies that are important to infrastructure and earn hard currency. Knowing that a company’s balance sheet will produce adequate cash flows under various scenarios to help insulate itself from a sovereign crisis takes time and experience.

Distinguishing reputable management teams that have executed cross-border deals is business-critical. Often overlooked, the existence of quality global resources and a mandate to deploy them aggressively across legal, technical and investigative disciplines is a critical part of the toolkit.

A gloomy macro environment emerging for several EM assets also presents an attractive entry point for companies currently valued at a significant discount. However, the right investment approach and analysis are essential to finding the differentiators.

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