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Emerging markets: Is the volatility contagious?

March 26, 2014

As economic problems grow in Turkey, Brazil, and other emerging markets, investors may be wondering whether it's 1997 all over again.

That was the year that financial problems in Thailand quickly spread to Indonesia, South Korea, and other Asian countries and threatened the world financial system.

Joe DavisVanguard Chief Economist Joe Davis sees similarities between now and then, but he also cited crucial differences that make current emerging market turmoil less worrisome than in the 1990s. Importantly, Mr. Davis sees investment opportunities in emerging markets that a disciplined approach to global investing and rebalancing can take advantage of over the long term.


  • Emerging market countries face many challenges, including declining competitiveness, falling commodity prices, difficulties attracting capital, deflation, and reduced global liquidity.
  • Current problems in emerging market countries are unlikely to threaten the global economy as they did in 1997 because many countries have strengthened their balance sheets, shifted to floating-rate currencies, and made other crucial changes since then.
  • Vanguard continues to believe that emerging markets play an important role in diversified equity portfolios.

He noted that advisors should expect lingering economic pressures in emerging markets such as Turkey, Brazil, India, Indonesia, and South Africa because some of the primary conditions that supported their previously strong growth are waning, he said. In particular, he cited the combination of weaker commodity prices, credit growth, and global liquidity as factors in the recent emerging market turbulence. But he also believes the problems in those countries are unlikely to sicken the global economy, assuming growth in China and the United States holds up. As a result, it's unlikely that current emerging market volatility will disrupt the tapering program of the U.S. Federal Reserve, Davis added.

"Declining competitiveness, falling commodity prices, fears of declining global liquidity and deflation, and difficulties attracting capital put these countries at risk," he said. "But that's where the economic similarities to 1997 end. I don't think these countries yet present systemic risk because many of them have stronger balance sheets, generally lower amounts of debt denominated in foreign currencies, and higher levels of reserves than they did back then."

Jonathan LemcoJonathan Lemco, a principal in Vanguard's Fixed Income Group, said the emerging market countries with investment-grade* debt have much stronger outlooks than those that don't.

Most of Vanguard's emerging market holdings are in countries with investment-grade securities.

"If anything, the macroeconomic fundamentals of many of the countries that we at Vanguard invest in remain reasonably strong," he said. "They have shown fiscal prudence and have built up reserves, and their growth so far this year is, for the most part, adequate."

There is another key difference between now and 1997: Fewer emerging markets have pegged their currencies to the U.S. dollar. In the 1990s these pegs made the economies vulnerable to a rapidly rising dollar, causing exports to fall and foreign money to rush elsewhere.

As a result, some emerging markets were forced to shift their fixed currencies to floating rates, which helps absorb shocks in the global economy, Mr. Davis said. This time, several emerging market currencies have already fallen 30% or more against the U.S. dollar over the past three years.**

While the drop is steep, it can help these countries because it makes their exports more competitive globally, especially when compared with goods priced in U.S. dollars.

Vulnerable economies with flexible currencies

Exchange rates of select countries versus U.S. dollar

Vulnerable economies with flexible currencies

Note: Represents trade-weighted average exchange rate for Argentina, Brazil, India, Indonesia, South Africa, and Turkey per U.S. dollar shown rebased to January 2010 = 100.

Sources: Vanguard calculations based on data from Moody's Data Buffet and the International Monetary Fund.

The economic slowdown in China could add to the woes of emerging market countries, Mr. Davis said, as China's targeted 7% growth rate*** may challenge other nations' growth models reliant on China's previous double-digit growth. But he believes this risk is not high and could be partially offset by strength in Japan and the United States and stabilization in parts of Europe.

He pointed out that investors who stuck with their investment plans through the 1998 riots in Indonesia and other troubling events are probably glad they did.

He also noted that not long ago, many investors were tempted by the "allure" of emerging markets, believing their returns would resoundingly trump those of developed markets. This belief resulted in strong cash inflows before a protracted period of underperformance. In fact, Vanguard authored a research report in 2010 that cautioned investing in emerging market stocks simply based on their high growth rates.

Chasing returns in emerging markets

Cash flow versus outperformance of developed markets

Chasing returns in emerging markets

Note: Outperformance represents spread between rolling 3-year EM returns based on MSCI EM index and rolling 3-year developed market returns based on MSCI World Index. Cash flows represent rolling 1-year cash flows as a proportion of the previous month's assets under management. AUM is for all U.S.-domiciled mutual funds and ETFs, with data from Morningstar, Inc.

Sources: Vanguard calculations based on data from Thompson Reuters Datastream and Morningstar.

In fact, Mr. Davis pointed to that report (updated in 2013) to suggest that the attractiveness of emerging market stocks—in aggregate—is arguably stronger today than it was three years ago despite their lower expected growth rates. Recent emerging market headlines may provide advisors an opportunity to remind clients of the benefits of staying the course with diversified portfolios, he said, noting that disciplined investors are buying emerging market stocks right now even though cash flows industrywide are decidedly negative for emerging market stocks.

*Investment-grade fixed income securities are those rated the equivalent of Baa3 and above by Moody's.

**Vanguard calculations based on data from Moody's Data, Buffet and the International Monetary Fund.

***China sees expansion outweighing yuan, shadow bank risk. Bloomberg, February 23, 2014.


  • All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.
  • Investments in companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
  • Past performance is no guarantee of future returns.
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