How To Guard Against The Crisis Hidden In The Markets

How To Guard Against The Crisis Hidden In The Markets
Reda Farran, CFA

almost 2 years ago4 mins

  • Soaring food and energy prices, the rising cost of servicing debt, and China's economic slowdown are all major risks facing EMs at the moment – and some are more at risk than others.

  • A potential EM crisis – and subsequent spillover to other parts of the world – adds to the growing list of risks facing the global economy.

  • You can hedge against the possibility of an EM crisis by purchasing out-of-the-money put options on EM stocks and certain bond ETFs

Soaring food and energy prices, the rising cost of servicing debt, and China's economic slowdown are all major risks facing EMs at the moment – and some are more at risk than others.

A potential EM crisis – and subsequent spillover to other parts of the world – adds to the growing list of risks facing the global economy.

You can hedge against the possibility of an EM crisis by purchasing out-of-the-money put options on EM stocks and certain bond ETFs

We’re facing so many crises in the markets right now that you probably don’t want to hear about another one. But the reality is that EMs haven’t been this at risk since the 1990s, and they’re more tied up with the global economy – and, ultimately, your portfolio – than you might think. So let’s take a closer look at why they could be set for a crisis, and how you can protect your portfolio if it happens.

Why are emerging markets at risk?

1. Higher food and energy prices

Global energy prices have soared to multi-year highs in the wake of the Russia-Ukraine conflict, and since the two countries account for 12% of all calories traded globally, world food prices have surged to new records.

EM populations are typically hit harder by higher food and energy prices, because they spend a bigger percentage of their incomes on those basic needs. That means the price rises not only dent consumer spending and consequently economic growth, they can also lead to social unrest. And that’s already underway, with street protests recently erupting in Tunisia, Sri Lanka, and Peru. Tunisia is of particular interest: it’s where the Arab Spring uprisings – which turned violent in several countries – began in the wake of skyrocketing food prices over a decade ago.

2. Rising cost of servicing debt

Governments all over the developing world stepped up their borrowing to cushion the economic impact of the pandemic. But the cost of servicing that debt – which EMs often denominate in dollars – is climbing dramatically as the US Federal Reserve (the Fed) embarks on its most aggressive rate hiking campaign in decades. Those higher interest rates also make the currency more appealing to international savers and investors, which pushes up the value of the dollar. And that, in turn, makes it more expensive to pay back dollar-denominated debt when exchanged back into EMs’ local currencies.

Look at Sri Lanka, which suspended foreign debt payments to investors earlier this month and decided to use what’s left of its foreign currency reserves to cover food and energy imports. It’s not the only EM struggling to pay back its debt: the IMF estimates that 60% of low-income countries are either in or at high risk of debt distress, and Bloomberg Economics has highlighted five particular countries – Tunisia, Ethiopia, Pakistan, Ghana, and El Salvador – in immediate danger of being unable to repay their loans.

The five highlighted countries have large debt piles and borrowing costs that have risen by more than seven percentage points since 2019. Source: Bloomberg
The five highlighted countries have large debt piles and borrowing costs that have risen by more than seven percentage points since 2019. Source: Bloomberg

3. China’s economic slowdown

With virus outbreaks continuing and the Chinese government doubling down on its “Covid Zero” approach, the country’s economy – which plays an important role in fueling global growth – is slowing down considerably. A whole host of investment bank economists recently slashed their 2022 growth forecasts for China as a result. That’s bad news because of China’s sheer size and demand for goods, which makes it a vital destination for many EM countries’ exports. As China’s economy struggles, it’s likely to have direct knock-on effects for EM economies – especially those in Asia.

How could that impact EM investing?

EMs aren’t a monolith: they aren’t all impacted in the same way by the above issues, which means country selection plays an important role when you invest in EMs. For example, Bloomberg Economics puts Turkey, Egypt, and Vietnam top of the list of major EMs exposed to economic and financial spillovers from the Russia-Ukraine war.

Turkey, Egypt, and Vietnam head the Bloomberg Economics list of major EMs vulnerable to fallout from the war in Ukraine. Source: Bloomberg
Turkey, Egypt, and Vietnam head the Bloomberg Economics list of major EMs vulnerable to fallout from the war in Ukraine. Source: Bloomberg

But then you have many EM countries, especially in Latin America, that export commodities and whose economies stand to benefit from rising prices. Brazil’s real is among the world’s best-performing currencies this year, for example, and Chile’s exports were up more than 20% in March from a year earlier.

How could it impact your investments?

For the global economy, the direct impact of a debt default in a few EM countries would be small. But crises in the developing world have a history of spreading well beyond their starting points.

EMs contribute the most to global growth, after all, and their large populations make them a vital source of demand for goods. So if a series of crises sink EM economies, it would seriously dent global growth at a time when it’s already falling – and may just be the final nail on the coffin that tips the global economy into recession.

A full-blown EM crisis and its contagion effects could pose a serious risk to your portfolio, so you might want to consider hedging against the possibility. You can do that directly by buying out-of-the-money put options on EM-focused ETFs. They’re not just a good hedge, either: their value increases with volatility, so they can protect you from both falling prices and rising uncertainty. Alternatively, you could do it indirectly by purchasing safe havens like gold.

In terms of ETFs, I’d highlight the iShares MSCI Emerging Markets ex China ETF (ticker: EMXC). This is the largest EM stocks ETF that excludes China. Why exclude China? Because its sheer size has a disproportionate impact on an EM stock ETF’s weighting. And since its economy and markets are more closed in nature, the country’s also slightly more immune to a wider EM shock. As for EM debt, the largest ETF in the space is the iShares J.P. Morgan USD Emerging Markets Bond ETF (ticker: EMB).

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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