Morgan Stanley calls them “The Fragile Five.” They’re a group of nations that are home to 1.8 billion people and roughly $6 trillion in annual economic activity. They also have some of the world’s most vulnerable currencies which, as a result, have been plunging against the dollar and hammering returns for U.S. investors.
Brazil, India, Indonesia, South Africa and Turkey have become pariahs among emerging market investors, tainting the image of many of their brethren, too. But these countries have only themselves to blame because they grew addicted to imports and paid for them with foreign funds.
Yet it pays to track the moves of these struggling economies. “Countries that announce structural reforms are bound to get more investor interest,” says Russ Koesterich, chief investment strategist for BlackRock Inc. Koesterich adds that emerging markets are now “undeniably cheap…it’s an unappreciated asset class.”
The iShares MSCI EM Index ETF is down roughly 10 percent over the past year versus a 23 percent gain for the S&P 500.
Alec Young, global equity strategist at S&P Capital IQ, believes low valuations aren’t enough. “Everything starts with the currency against the dollar,” he says, predicting that some of the weakest global currencies such as the Turkish lira and the South African rand may weaken further as current economic stresses deepen. “It’s a risky way to bottom-fish.”
Jeremy Schwartz, research director at WisdomTree, is also keeping a close on eye on the beleaguered emerging market currencies. “A weak currency can actually bolster returns for U.S. investors once they reverse course,” he says.
For now, these strategists say investors should focus on emerging markets that run trade surpluses or at least have proven their ability to keep attracting foreign funds, are implementing meaningful reforms, and are expected to deliver export-fueled growth.
iShares MSCI Mexico Capped ETF (EWW)
Mexico typically generates a $60 billion annual trading surplus with the U.S., according to census.gov. And the trend should show no sign of letting up in 2014, as U.S. GDP is expected to rise nearly 3% this year, creating an even stronger appetite for Mexican imports. Even though the U.S. and Mexico are deeply inter-twined, investor interest has diverged as this ETF has underperformed the S&P 500 by roughly 30 percentage points both on a one-year and two-year basis (the latter isn’t annualized; it’s absolute).
Mexican governance is also getting higher marks as President Enrique Pena Nieto pursues his “Pact for Mexico,” which has greatly increased bipartisanship. The country has been quashing telecom monopolies while opening up its energy sector to foreign investment, and that step recently led S&P to boost its credit rating for Mexico, calling the energy reforms a “watershed moment.”