Since bottoming on February 5, the MSCI Emerging Markets Index has returned more than 10%, dragging year-to-date returns into the black. Yields on EM debt, meanwhile, have fallen sharply, and many EM currencies have posted strong gains. At the same time, Chinese growth appears to be slowing and debt problems mounting, while the “Fragile 5” (Brazil, India, Indonesia, South Africa, and Turkey) exhibit all the signs of a classic balance of payments crisis that will get worse before it gets better.

The current rally could certainly continue—particularly if one or more developed markets central banks ramps up quantitative easing—but in our opinion the near-term risks are tilted to the downside. Further, while we believe emerging markets are relatively cheap and thus worth owning for the long term, it is important to stress the divergent valuations within these markets. Emerging markets’ discount to developed markets, for example, all but disappears once various state-owned enterprises (e.g., Gazprom and Chinese banks and oil companies) are removed.

A Short History of Balance of Payments Crises
Over the short term, macro factors appear decidedly tilted against emerging markets. Given the history of BOP crises, the Fragile 5 appear to be in the very early stages of adjustment. Very briefly, BOP crises tend to play out as follows:

• Strong growth, often resulting from fundamental improvements, attracts capital.
• Virtuous cycle as capital flows boost asset prices and demand, attracting more capital.
• Capital flows drive up exchange rate, hurting competitiveness even as consumption continues to increase (dependence on capital flows is now at a peak).
• Event (often minor) sparks capital flight, driving down asset prices and creating a vicious cycle as interest rates rise, hurting growth and driving out more capital.
• At this point central banks generally either spend down reserves or hike rates to defend the currency and damp inflation (but at the expense of crushing growth); neither tends to work, and the crisis continues until the external financing gap is closed, which typically does not happen until the currency declines enough to improve competiveness, and consumers bring spending in line with income.

Compared to prior BOP crises, the Fragile 5 remain firmly in the “bust” phase—by one estimate, real effective exchange rates would need to fall some 20% from current levels to match prior falls.

China, meanwhile, continues to struggle with slowing growth and the leading edge of a potential debt crisis some have compared to the 2008 crisis. Since 2008, China’s credit market has grown from US$9 trillion to US$23 trillion, compared to GDP of about US$9 trillion, and cracks have started to appear. A number of “investment trusts”—products that guaranteed investors a specified rate of return—have required bailouts, while the country’s domestic bond market suffered its first-ever defaults in March.

While most observers seem of the opinion that Chinese leadership will “manage” the situation better than US authorities handled the 2008 crisis, this is eerily reminiscent of investor optimism in 2007/early 2008 that the subprime crisis was “contained.”

Finally, the Russia-Ukraine crisis remains an unpredictable and volatile situation with potentially large knock-on effects should hostilities escalate.

Conclusion
EM equities look cheap in aggregate, due primarily to a small subset of companies trading at depressed valuations; macro risks, meanwhile, seem tilted to the downside. That said, given that the “event” that kicked off this crisis was clearly the Federal Reserve’s much-discussed taper, the biggest short-term “risk” to the upside is more aggressive central bank activities. To wit, a reversal of the taper, or even just a pause, could send risk assets higher across the board, as could the European Central Bank enacting its own version of quantitative easing, or even a reacceleration of Chinese credit growth.

Eric Winig is a Managing Director on the Cambridge Associates Global Investment Research team.