What Canadian Investors Should Know About The Fragile 5

What should Canadian investors understand about the Fragile 5 economies?

Concern about growth in China and other emerging markets triggered a wave of selling in less developed economies last week. And the trend seems to be continuing.

Investors are waking up to the fact that many of the most accessible emerging markets now face challenges that dim their prospects. And that’s got them worried about a quickly spreading contagion taking down the entire region in lockstep. Already, the chain reaction has wiped roughly $1.8 trillion from global stocks.

What’s happening right now with these emerging markets – and how could they impact Canadian investors?

When Money Quickly Rushes Out

Not that long ago, emerging markets were seen as the bright spot in a stagnant global economy. But investors don’t invest in these regions the way they do on this side of the globe.

When these economies are hot, money rushes in; but when things cool, everyone jumps ship – usually with ever-increasing speed. So, it’s not surprising that, after chasing yields in more out-of-the-way spots, spooked North American investors are now bringing their money home.

And you might be wise to do the same, says Yves Rebetez, managing director and editor of investment newsletter ETFInsights.

A Shift Towards More Developed Markets

Canadians should probably raise their broad international exposure by concentrating on more developed markets, while maintaining – even though 2014 is unlikely to be a repeat of last year – a healthy exposure to the United States, he suggests.

At the very least analysts suggest being more selective when it comes to emerging markets, perhaps avoiding the so-called Fragile 5 (Brazil, India, Indonesia, Turkey and South Africa) that rely so heavily on outside capital –– and all of which face contested elections at some point in 2014.

At the same time, Canadians should consider reducing exposure to the Loonie, Rebetez adds. Our currency’s continued descent suggests exposure to any foreign equities should generally be unhedged in anticipation of the potential for additional weakness.

What’s All The Fuss About?

There are a number of political, economic, and currency forces sparking this emerging market panic.

The first is the U.S. Federal Reserve’s pullback on its massive stimulus spending. For a year and a half now, the Fed has pumped massive amounts of liquidity every month into the global market.

That had the effect of driving down the return investors could get from fixed income assets, so many sought more profitable opportunities elsewhere. While stacks of cash went into U.S. stocks, some went into emerging markets – which involved buying the local currencies, sending their values up dramatically.

The Tapering Effect

Now, the Fed is beginning to take its foot off the gas by reducing its bond buying spree. This is causing those local currencies to crumble and interest rates to soar as governments try to hang on to the foreign money they need to offset the deficits in their current accounts.

But hiking interest rates to keep attracting investors’ money to their bond markets will almost certainly crimp economic growth. As well, if they let their currencies slide, they risk the inflation that would likely come from higher import prices.

All that means that growth in emerging markets will, in all likelihood, be much harder to come by in the future. In fact, the economies of many emerging markets are already slowing, led by China – not only the world’s largest emerging economy, but also the biggest consumer of exports from other emerging markets.

With the broad MSCI Emerging Markets stock index down about eight per cent over the past month, is this the time for bolder investors to do some bottom fishing?

Not just yet, strategists at Pavilion Global Markets told the Globe and Mail: “The headwinds over emerging markets are strong at the moment and valuation alone is not a good enough reason to jump back into the space. In most cases, valuations are not appealing enough to make up for the large macro risks.”

 

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