It can be tempting to think of emerging markets (EM) as a single, monolithic category when it comes to investing. However, it’s important to remember that not all EM investments are the same. Yes, there are some broad similarities between EM countries—there’s a reason they’re all grouped together, after all—but each EM country’s stock market tends to be sensitive to different economic forces.
What are some of these factors? We looked at the countries in the MSCI Emerging Market Index, which measures EM stock market performance globally, and identified four big ones: sensitivity to developed markets, sensitivity to domestic economic forces, sensitivity to changes in currency markets and sensitivity to commodities markets.
We believe these sensitivities vary across the countries in the MSCI EM Index, and that investors would do well to remember that the decision to trade EM stocks shouldn’t come down to a single factor.
Developed market sensitivity
EM stock markets in countries that export a lot of goods and services to the developed world are particularly sensitive to events in developed economies. If growth and demand pick up in the developed world, you might expect that to give such EM countries a boost (and vice versa if demand from developed countries slows down).
South Korea and Taiwan lead the pack in this category, though Mexico, China, Hungary and Czech Republic are also fairly sensitive to changes in developed markets. Combined, these countries account for 57% of the MSCI EM index. Another issue here is that many of the companies in these countries' stock indexes are international, which helps insulate them from domestic economic conditions to a certain degree.
Domestic market focused
Stock markets in some EM countries are dominated by unique domestic factors that have little reference to events outside the countries’ borders.
For example, India’s stock market is sensitive to changes in domestic spending, and the fact that the country’s exports account for a relatively small share of the economy helps insulate Indian companies from events overseas. For China, the largest contributor to the economy is capital spending—that is, spending on equipment and the construction of factories, real estate and infrastructure—though that could change as the country’s leaders seem committed to boosting the contribution from consumer spending. In the case of Greece and Egypt, political factors, such as the Greek debt bailout and political turmoil have had an outsized impact on stock performance. Poland and the Philippines also fall into this category.
Taken together, countries with stock markets that are more sensitive to domestic conditions account for 38% of the MSCI EM Index. (Note that some stock markets are highly sensitive to more than one factor, so these tallies for the MSCI EM Index exceed 100%.)
Some EM stock markets are highly sensitive to fluctuations in the local currency. This has a lot to do with the local share of short-term debt denominated in other currencies, such as the dollar, relative to a country’s foreign exchange reserves.
South Africa, Turkey and Malaysia all have relatively large shares of short-term external debt relative to their reserves, as do Indonesia, Thailand and Colombia.
The issue here is that investors can become concerned when a local currency weakens, which makes it more difficult for local companies to service debt denominated in a stronger foreign currency. Short-term debt can be particularly problematic because of the constant need to roll it over as it matures. If currency markets happen to be volatile when a lot of debt is maturing, there’s a chance the market will dry up or interest rates will spike, making it difficult for local debtors to secure fresh financing. Countries with low foreign exchange reserves relative to the short-term external debt are less able to cover financing needs at times of currency market stress.
These factors can combine to drive stock investors out of local stocks if they foresee currency problems.
We have also included Brazil, Russia, Chile and Peru in this category because their stock markets started moving more closely in tandem with changes in the currency market ever since May 2013, when the Federal Reserve first talked about tapering its asset purchases, paving the way for the so-called Taper Tantrum.
Countries that are highly sensitive to changes in the currency market account for 29% of the MSCI EM Index.
Commodity-oriented EM countries
Some EM countries rely heavily on commodity exports or otherwise have stock markets with energy or materials sectors that are larger than the emerging market average. These countries’ stock markets may be particularly sensitive to changes in the global commodities markets.
Countries in this group include Indonesia, the United Arab Emirates and Qatar. We also included Brazil, South Africa, Russia, Chile and Peru, as these countries’ markets are sensitive to changes in both the currency and commodities markets. Altogether, commodity-sensitive stock markets account for about 26% of the MSCI EM Index.
As you can see, EM stock markets aren’t interchangeable, with each responding in different ways to different economic factors. It’s important to keep that in mind if you’re planning to invest in EM stocks for a particular reason. For example, if a recovery in commodities inspired you to look for EM stocks to take advantage, you may want to consider countries that have higher exposure to commodities rather than broader EM stock investments. Again, the decision to trade emerging markets stocks therefore shouldn’t come down to a single factor.
It’s also worth noting that the sensitivities we discussed above aren’t the only factors driving particular EM stock markets. Other factors can come into play and geopolitical risks could arise suddenly.
At the end of the day, EM stocks offer potential growth and diversification benefits that should qualify them for a place in most portfolios, particularly for investors with moderate to higher risk tolerances. If you’re considering emerging-market investments, the first step is to see how your current asset allocation stacks up against your target allocation. For more details, clients can use the Schwab Portfolio Checkup tool.