There’s a lot to like about emerging market stocks.
As we explained yesterday, they’re cheap. They’re in an uptrend. And their economies are growing quickly.
Plus, commodities are rising for the first time in years. That’s given them a big boost.
But like any investment, there are risks you have to consider.
Today, we’re going to look at the biggest threat to emerging markets. But don’t worry. There’s a way to get around this risk. We’ll explain how at the end of this essay.
But first, you need to understand what’s going on in the global currency market…
• The US dollar has broken out of its 30-year downtrend…
The chart below shows the performance of the US Dollar Index going back to early 1970s.
You can see this index peaked in the mid-1980s. It went on to fall for about three decades.
Then, in early 2015, it broke out of its downtrend. It’s since surged about 10%. That’s a huge move for the world’s most important currency.
To be clear, the chart above tracks the dollar’s performance against other major currencies like the Japanese yen and euro. It doesn’t show how the dollar’s done against emerging market currencies.
But the dollar’s done even better against these fragile currencies.
Over the past two years, the dollar’s up 37% on the Mexican peso… 48% against the Turkish lira… and 80% against the Argentine peso. The list goes on.
This is creating huge problems for many emerging markets. To understand why, let’s go back to 2009.
• Back then, the U.S. was battling its worst economic crisis since the Great Depression…
To stimulate the economy, the Federal Reserve dropped its key interest rate close to zero. It left it there for eight years.
Regular readers know this did almost nothing for the “real” economy. About all it did was encourage a lot of reckless borrowing.
U.S. corporations have borrowed almost $9.5 trillion in the bond market since 2009. That’s 61% more than they borrowed in the eight years prior to the 2008–2009 financial crisis.
• Foreign companies loaded up on cheap U.S. debt, too…
According to the Bank for International Settlements (BIS), emerging market companies now have more than $3 trillion in U.S. dollar-denominated debt. That’s more than the annual economic output of the United Kingdom, the world’s fifth-biggest economy.
For years, all this debt wasn’t a problem. The dollar was weak. But, as we just showed you, that’s no longer the case.
• Plus, U.S. interest rates are rising for the first time in over a decade…
As you’ve probably heard, the Fed raised its key interest rate by 0.25% in December.
The Fed also said that it wants to raise rates three more times this year.
If the Fed sticks to its plan, U.S. bonds could soon yield a lot more. This will make U.S. assets more attractive to foreign investors.
That would be bullish for the US dollar, which would make “cheap” debt held overseas a lot more expensive.
• This would create major problems for emerging market companies…
To see why, look at the chart below.
The green line is the US Dollar Index. The blue line is the WisdomTree Emerging Markets Corporate Bond Fund (EMCB). This fund tracks the performance of U.S. dollar-denominated bonds issued by companies in emerging markets.
The highlighted areas show that the EMCB and the US Dollar Index are inversely correlated. When one zigs, the other zags.
This isn’t surprising.
A strong dollar makes it hard for many emerging market companies to pay off their debts. This is why EMCB often falls when the US Dollar Index jumps higher.
• You can see why a rising dollar is a major threat to emerging markets…
But this doesn’t mean you should avoid all emerging market stocks today…
You just have to own the right ones. Here’s how you can stack the odds in your favor…
Invest in countries with low levels of “external debt.” This is debt issued in foreign currencies. These days, a lot of external debt is denominated in dollars.
According to global investment bank Société Générale, Russia, Brazil, and India have relatively low levels of external debt.
Turkey, Chile, and the Philippines, on the other hand, have much higher levels of external debt. This makes them riskier.
Once you find a country you would want to invest in, the next step is to pick a great company…
Invest in the right sectors. According to Société Générale, “extractive industries” have by far the highest external debt levels of any sector in emerging markets. This group includes miners and oil and gas companies.
Telecommunication, utility, and food and beverage companies have much lower external debt levels. These are safer industries to be in if the dollar keeps rising.
“We’re buying a situation that can only get better”…
That’s what E.B. Tucker told readers in the December issue of The Casey Report. He was talking about Russia’s currency, the ruble.
You can see what E.B. means in the chart below. This chart shows the performance of the Russian ruble since 2000. You can see it’s now worth about half as much as it was seventeen years ago.
But E.B. doesn’t think the ruble will stay this low for much longer.
To profit from a stronger ruble, E.B. recommended buying one of Russia’s largest companies. The company has a monopoly on one of Russia’s most important exports. It’s one of the most dominant companies on the planet.
We’ll have more to say about this opportunity in the coming weeks.
Courtesy: Justin Spittler
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