The last few weeks have had plenty of good news for emerging markets—and some not-great news as well.
First the good: investors definitely showed emerging markets some love in March—emerging markets exchange-traded funds (ETFs) drew a goodly share of investment flows during the last week of March, according to Bloomberg. All told, investors put a net US$1.6 billion into emerging markets ETFs focused on equities and bonds in the five days through March 28.
Flows into the iShares MSCI Emerging Markets ETF alone accounted for US$1.4 billion.
That’s a sign investors are again confident in the ability of emerging markets to bounce back from what was a fairly hefty sell-off earlier this year.
As Bloomberg notes, emerging markets stocks are trading at a 33% discount to stocks from developed markets—and there are signs that countries such as India and Indonesia have taken meaningful steps to narrow their current account deficits.
And all those signs are making investors happy—but are they getting overexcited? Well, according to the latest report on global financial stability coming out of the International Monetary Fund (IMF), all that positive sentiment surrounding emerging markets might be a bit premature.
As the IMF warns, some emerging economies still have some big challenges ahead as they grapple with developed market challenges like leveraged balance sheets on both the private and public side. Debt is making some economies much more sensitive to any changes in domestic and external conditions and, hence, more vulnerable to shocks.
Corporate bonds are a particular area of note for the IMF: while some companies are in relatively good shape to withstand shocks, some quite plainly are over-leveraged—to the tune of US$740 billion.
In a severe and adverse scenario where borrowing costs escalate and earnings deteriorate significantly, the debt at risk held by weaker, highly leveraged firms could increase by $740 billion, rising, on average, to 35% of total corporate debt in the sample of firms.
Most emerging markets economies do seem to have adequate bank capital buffers along with a solid outlook for profitability. But several economies aren’t in great shape, and those should be of concern to investors.
So what does this mean for investors? Sure, there’s plenty to be bullish on when it comes to emerging markets but investors can no longer just look at these countries as a blanket asset class. And, when it comes to ETFs, it’s more important than ever to consider going beyond the broad index.
I talked about this here a few months ago—specialized exposure or country-focused ETFs can help investors to strip out areas that are the weakest and to focus on the strengths. So while it’s a good time to feel positive about emerging markets, the message is clear: not all of them are on the same path, and some clearly face bumps in the road. The best strategy is one that aims to drive around them.