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 theirmoney out of emerging-marketstocks
andbonds 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 offactors to consider. They are interrelated and
can help determine which bonds are safe -- and which are
potentially toxic. Those three factors: trade balances,
foreigncurrency reserves and currency changes. Let's take a
Surplus OrDeficit ?
A nation'strade balance is likely the single most important item
you need to track as you assess emerging markets. A nation that
runs a strongtrade surplus is likely to retain a firm currency
over a multi-year period. And countries that runtrade deficits
are extremely vulnerable, as they depend on globalcapital to help
keep theireconomy and currency from collapsing.
For instance, India, which runs stubbornly large trade
deficits, is currently seeing a massive run on both the rupee and
itsstock andbond markets. Global investors have already assumed
that the Indian economy is headed for very tough times as capital
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 ofGDP .
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 runningtrade 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 bythe 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
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
) 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
a basket ofkey 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-termgains . In the
nearterm , a weaker currency for any nation that runs trade
deficits means that import prices are rising, and an upward move
ininflation 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
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 theseissues and
proceed only when countries show relative health interms of trade
balances and foreign currency reserves.
Action to Take -->
Across emerging markets, Asia remains as a notable brightspot ,
especially as fears of a deeper economic slowdown in China are
starting tofade . That makes emerging-market bondETFs
increasingly appealing, as they are being sold off in tandem with
truly vulnerable bonds issued elsewhere. The
WisdomTree Asia LocalDebt ETF (
, for example, is touching 52-week lows after falling 10% since
early May. Thefund invests in "fixed-income securities issued by
Asia ex-Japan governments, agencies and corporations denominated
in the local currency," according to the ETF'sprospectus .
Investors may also want to check out the
SPDR Barclays Capital EM Local Bond ETF (Nasdaq:
. 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, thedefault risk is minimal. And
thecurrent 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 alot of resiliency in the
past. I recently discussed the appeal of the
iShares MSCI Emerging Markets ETF (
and still think that its blue-chip portfolio is gong
unappreciated by global investors.
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