How to Spot Opportunities in Emerging Market Cycles
Everything You Need to Know About Emerging Market Business Cycles
Emerging markets represent a key area of growth for international investors looking to build a diversified portfolio. But, they also entail a lot more risk and volatility than developed markets like the United States or Europe. This volatility stems from emerging market business cycles, which tend to be a lot more volatile than developed markets for a variety of reasons. By understanding these cycles, investors can increase their odds of success in these markets.
In this article, we will look at emerging market cycles and how international investors can use them to spot opportunities, as well as some examples of these business cycles at work.
What Are Business Cycles?
Business cycles — or economic cycles — represent the upward and downward movement of gross domestic product (GDP) throughout a long-term trend. These cycles consist of an expansion, crisis, recession, and recovery period that repeat over time.
Expansions are characterized by increased production, inflation, and low interest rates; crises are characterized by stock crashes and bankruptcies; recessions are characterized by falling prices and higher interest rates; and, recoveries are characterized by stock recoveries and falling prices and incomes. The process repeats when falling prices lead to increased consumption, which leads to higher income, and ultimately, back to inflation and increased production.
For example, the United States experienced a period of expansion leading up to 2007 when the subprime mortgage crisis. A recession followed the crisis and lasted until early-2010 when a recovery began. Since then, the U.S. economy has experienced a new period of expansion. This same process has repeated itself many times throughout the country’s history, including the dot-com crash in the early-2000s and due to political issues in the 1970s and 1980s.
Emerging Market Cycles
Emerging market business cycles are characterized by strongly countercyclical current accounts, consumption volatility that exceeds income volatility, and “sudden stops” in capital inflows, according to Mark Aguiar of the University of Rochester. These characteristics come from frequent regime changes that dramatically impact fiscal, monetary, and trade policies, which in turn has a dramatic impact on a country’s economic growth.
Emerging market economies are also more exposed to external factors than developed economies that rely primarily on internal consumption. For instance, many emerging markets rely on exports to drive economic growth. The value of these exports is influenced by a combination of external demand and currency valuations. This explains why countries like China are keen on carefully controlling the value of their currency.
Business cycle volatility in developed markets has been declining in recent decades, but emerging markets have seen a dramatic increase in volatility. These trends have translated to increased volatility for emerging market equities. For instance, the iShares MSCI Emerging Markets Index ETF (NYSE: EEM) has a beta coefficient of 1.26, as of June 2017, which means that the index is about 26 percent more volatile than the U.S. S&P 500 index.
As anyone who purchased U.S. stocks in 2008 knows, this volatility creates an opportunity for international investors to buy low and sell high. The problem is identifying when to buy or sell emerging market equities based on where a country is within a business cycle.
The three most important factors to watch include:
- U.S. Interest Rates: Many emerging markets have dollar-denominated sovereign debt and corporate debt, which means that the “cost” of the debt is dependent on the U.S. dollar’s valuation relative to local currency. Higher interest rates translate to a stronger dollar, which makes dollar-denominated debt more expensive, and vice versa.
- Political Change: Emerging market business cycles are driven largely by political regime changes, which can influence monetary policy, fiscal policy, and geopolitical risks. As a result, international investors should pay close attention to any political changes and the potential impact that they could have on the business cycle.
- External Factors: Emerging market business cycles are also influenced by many external factors, including export demand and geopolitical conflict. International investors should take any of these factors into account since they can have a great impact on economic growth.
There are many examples of these factors at play:
- Argentina: The election of Mauricio Macri in Argentina represented a significant political change that helped dramatically boost the country’s equity markets.
- Mexico: The election of Donald Trump in the United States was an external factor that hurt Mexico’s equity markets due to anticipated policy changes.
- Broad Emerging Markets: The prospect for an increase in interest rates — at the time — led to negative capital flows for emerging markets in 2015.
The Bottom Line
Emerging markets represent a great opportunity for international investors to generate above-average risk-adjusted returns. This is best accomplished by reading emerging market business cycles and buying and selling at opportune times. These cycles are driven by a combination of U.S. interest rates, political changes, and various external factors, which international investors should keep an eye on to spot opportunities to profit.