In 1988, Morgan Stanley created the MSCI Emerging Markets Index, the benchmark for measuring the performances of emerging markets. There have been booms and busts in emerging markets over the years, and they are currently in a bust period. Since September 2014, the index is down 34% in a clear bear market. Emerging market currencies have followed the same path; the WisdomTree Emerging Currency Strategy Fund is down over 20% for the same period.

French investment bank BNP Paribas says that emerging markets are victims of a triple shock that encompasses China's slowdown, falling commodity prices and a stronger U.S. dollar. Risk for emerging market equities remains high in 2016 as a worldwide downturn in equities continues.

Dependence on Commodities

The international Monetary Fund (IMF) forecasts 2016 as another down year for oil and the fifth consecutive down year for other commodities. Commodity investment firms are aggressively scaling back investment in emerging markets. Before the bust in commodities commenced five years ago, developing economies were lifted by the rapid growth of Chinese demand during a massive investment boom. Commodity exporters prospered, especially in Latin America and Africa, as Chinese demand consumed almost half the worldwide production of industrial metals. China hit the wall, however, and emerging market countries lost their major customer. They are left with a highly leveraged infrastructure, plummeting capital inflows and reduced liquidity.

Strong Dollar

The U.S. dollar has strengthened by 8% since August 2015, crushing emerging market currencies in the process. With the Federal Reserve in tightening mode, this imbalance is poised to continue. Weakening currencies can be inflationary because they raise the cost of imports. A classic economic response is to raise rates to support the weakening currency at the cost of depressing economic activity. This is not an option for most commodity-oriented developing countries; many are already teetering on the edge of recession. Higher rates will also increase the cost of servicing debt, and many of these countries are heavily indebted. If the Fed takes it slow in its tightening campaign and the dollar levels off, emerging market monetary authorities will breathe easier, and stock markets will have a better chance of recovery when the current bear phase relents.

Heavy Indebtedness

Corporate debt in developing countries has soared in the past few years and represents a clear headwind to a healing of debt and equity markets. The Bank for International Settlements (BIS) estimates that total emerging market corporate debt is now at $25 trillion, growing by $10 trillion just in the past five years. In the process, the emerging market debt to GDP ratio jumped to 90 from 45% in 2010.

Corporations became aggressively leveraged, believing that China's ravenous appetite for commodities would continue to grow. This mindset has parallels to the U.S. subprime real estate debt tsunami that ushered in the 2008 financial collapse.

In the last seven years, developing countries issued $6.8 trillion in corporate bonds, with 30% of the debt denominated in U.S. dollars. The currency implosion in these countries makes the cost of servicing dollar-denominated debt even more onerous. Potential investors wonder when the defaults will start, and that is not a good environment for risk-taking in emerging market equities.

Investor Outflows

Investor outflows from emerging markets didn't exceed inflows for 27 years, but that may have changed in 2015. Foreign inflows are expected to be half the levels of 2014. This contrasts with 2010, for example, when investors put a net $22 billion into emerging market stocks and bonds every month. In November 2015, a net $3.5 billion was pulled out. To add to the pain, local outflows are also increasing. Some analysts argue that emerging market securities have fallen to levels that make accumulation attractive to long-term investors, but no one knows how bad these markets will get until a turn arrives.

Too Many Negatives

There is no doubt that emerging market equities will attract investors again someday, but that day is not imminent based on the accumulation of negative signposts. It is boom and bust cycle in this sector, and right now, the bust reigns supreme.

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