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Emerging-Market Stocks Enter Bear Territory -- 2nd Update

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09/06/2018 | 11:37pm CEST

By Mike Bird in Hong Kong, Riva Gold in London and Ira Iosebashvili in New York

Emerging markets tipped into bear territory on Thursday, marking investors' retreat from risky assets amid growing concerns about the outlook for the global economy.

The MSCI Emerging Markets Index's 0.3% decline Thursday, led by selloffs in Russia and the Philippines, pushed that gauge of stocks in poorer countries 20% below its recent peak, the common definition of a bear market. The drop deepened a swoon that began last month with sharp falls in the shares and currencies of Turkey and Argentina, both of which are facing domestic economic and political crises.

The emerging-markets decline underscores the changing dynamics evident across financial markets, which have benefited from years of central bank stimulus and recently from a period of synchronized global growth but are now facing challenging conditions.

Tightening monetary policy, along with an upsurge of nationalism that has hampered global trade, is exacerbating the stresses in many developing countries, prompting investors to scramble to distinguish economies able to weather the storm from those too feeble to cope.

While U.S. stocks remain near records and signs of contagion are few, investors are closely watching the rout in emerging markets for signs that it is spilling over into the assets of developed countries.

"My fear of contagion is that right now the sentiment towards the whole emerging-market spectrum is very fragile," said Mario Castro, a Latin America currency strategist at Nomura.

Threading these economies together is their use of the dollar to borrow funds. When the U.S. economy looks to be in much better health than the rest of the world and the Federal Reserve lifts interest rates, pushing the greenback higher, upheaval often follows in the developing world.

Emerging markets have also been hit hard by concerns that tariffs applied by the U.S. and China on each others' goods could prompt further protectionist moves and upset global trade.

The Shanghai Composite Index has fallen 24% from its peak in January, while the yuan is down nearly 7% since June.

The recent bout of selling was partly triggered last month by sharp declines in the Turkish lira, which is down by more than 42% this year, and later the Argentine peso, which has fallen by around 50%. Elsewhere, the Indian rupee reached its weakest-ever levels this week, and the Indonesian rupiah is trading around two-decade lows.

This is neither a string of unrelated blowups nor a meltdown in which contagion spreads by panic selling moving from nation to nation. It is somewhere in the middle, creating both dangers and opportunities for investors.

Many markets face similar issues: While U.S. manufacturing output probably grew at its fastest in 14 years in August, according to Institute for Supply Management surveys, a poll of purchasing managers in manufacturing firms around the world, published by JPMorgan and IHS Markit, showed the slowest output growth in nearly two years.

Raw-materials prices have also faltered, with the Bloomberg Commodity Index falling nearly 10% since its peak in May. That puts pressure on major exporters of commodities other than oil, such as Brazil, Chile and Indonesia.

Moreover, many investors buy emerging-market assets in broad funds, rather than country by country. So when they reduce exposure, developing markets can be hit all at once.

"There are a lot of people out there who are distressed sellers or forced sellers," said Mark Tinker, head of the Framlington Equities Asia business at AXA Investment Managers.

The links extend into developed markets such as Western Europe, given the region's lending ties to countries including Russia and Turkey and its trading ties with China.

Mr. Castro said much was riding on a presidential vote this year in Brazil that will decide whether the country enacts changes to keep its economy healthy and debt in check. "There is a lot at play in the elections, and Brazil is systemically important for emerging markets," he said.

Money managers also say it is possible to distinguish clearly between different kinds of developing nations.

"There is a debt crisis in emerging markets. They've just racked up way too much debt, and those chickens are coming home to roost. But we need to differentiate clearly when we talk about these concerns," said Bryan Carter, head of emerging-market debt at BNP Paribas Asset Management.

"You can separate almost all countries into one or two camps: the countries with central banks that have decided to keep up with the Fed and hike rates, and those that have consciously decided not to," he added.

Argentina, Mr. Carter said, was in the first camp. The country's bonds were his largest single overweight position, he said, based in part on the country's orthodox economic governance. In contrast, Brazil and South Africa have allowed their currencies to take the strain rather than raise interest rates.

Others note that China has successfully taken yet another path, amping up spending and loosening monetary policy rather than following the Fed. As a consequence, while shares have fallen sharply this year, prices of Chinese government debt have risen, sending yields lower, in contrast to other emerging markets.

"My view is that China has already become less EM-like than it was in 2016," said Karthik Sankaran, director of global strategy at Eurasia Group. A previous growth scare gripped Chinese markets in 2015-16.

Even in more vulnerable countries, some fund managers are snapping up securities issued by companies that are stronger than their domestic economies. "You have companies in Indonesia that are very export oriented, with no foreign debt. That's an absolute winner," said Leon Goldfeld, a multiasset portfolio manager at J.P. Morgan Asset Management.

Write to Mike Bird at Mike.Bird@wsj.com, Riva Gold at riva.gold@wsj.com and Ira Iosebashvili at ira.iosebashvili@wsj.com

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