3 Economic Warning Signs Global Investors Need to Know

How External Dependencies and Inflation Drive Economies

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International investing is notoriously difficult. In addition to fundamental analysis, investors must account for things like geopolitical risks and currency risks. Most experts suggest using global mutual funds and exchange-traded funds (ETFs) to build exposure to these markets without worrying about the specifics. But in some cases, it pays to pay attention to the risks and limit exposure to certain countries that are set up for economic problems.

In this article, we’ll take a look at some warning signs that may be a precursor to widespread economic problems in a country.

Commodity Dependence

Many emerging markets are dependent on a single or group of commodities to drive their economic growth. With the fall in crude oil in 2015 and 2016, many of these emerging markets experienced a sharp reduction in revenue.

International investors should be aware of commodity dependence when building their portfolios in order to avoid these downturns. While predicting crude oil’s decline may have been difficult, ensuring that a portfolio wasn’t concentrated in oil-dependent countries could have saved investors from a lot of losses during the period. The same is true for countries dependent on hard commodities like copper or iron-ore.

The easiest way to determine commodity dependence is to look at a country ETF and identify what sectors dominate the fund’s assets.

As of February 2016, the iShares MSCI Brazil Capped ETF (NYSE ARCA: EWZ) had 8.76% exposure to energy and 9.85% exposure to materials, which means that it had a lot riding on energy and commodity prices. By comparison, the S&P 500 had 6.73% exposure to energy and 2.77% exposure to materials.

Country Dependence

Many countries have a high dependency on external countries for their growth, which can create problems when those external countries experience a slowdown.

In contrast, the U.S. generates the majority of its growth internally through the services sector.

Australia is the classic example of a country that is dependent on another country for an outsized portion of its growth. With China as its largest trading partner, by a wide margin, the country’s stock market sank nearly 25% between February 2015 and February 2016, as the Chinese market slid about 30% over the same period. By comparison, the U.S. S&P 500 fell just 9% over the period, as it’s less tied to China’s fate than Australia.

The easiest way to determine a country’s dependence on another country is to take a look at their major trading partners. While forecasting the decline of a trading partner is impractical, international investors can group their investments by country exposure to ensure diversification. For example, an investor holding Australian and Chinese ETFs will know that their portfolio may not be diversified enough when combining that exposure.

Inflation & Deflation

Inflation and deflation are the two most important factors to look at when analyzing a country’s economy. In fact, managing inflation is the single most important mandate for most central banks around the world, which means it tends to drive monetary policy decisions.

Inflation occurs when prices rise within an economy, which may occur due to demand growth from consumers or increased costs for suppliers. In other cases, inflation is caused by central governments increasing the money supply, which ends up reducing a currency’s value. These dynamics happened in Venezuela in 2015 and 2016 and led to hyper inflation that exceeded 60% per year and caused widespread economic and social damages.

Deflation can be equally as dangerous. When consumers believe that prices will move lower, they may hold off on purchasing items, forcing suppliers to cut prices. This cycle has occurred in a number of different countries, including Japan during the so-called Lost Decade. Investors are also concerned that these dynamics may be occurring throughout a wider part of the developed world in 2016 as negative interest rates aren’t sufficient to spur spending.

Key Takeaway Points

  • International investing may be more difficult than domestic investing, but global mutual funds and ETFs make it easy to build exposure into any portfolios.
  • Commodity dependence can become dangerous if a portfolio is too concentrated in countries dependent on the same commodity – such as crude oil.
  • Country dependence can become a problem when a significant portion of a portfolio is dependent on a single country for their growth.
  • Inflation and deflation are two of the most important indicators to watch, since they drive monetary policy decisions at central banks.