The connection between Thursday's dovish statement from the European Central Bank (ECB) and emerging markets (EM) may seem a little indirect, but the effect the ECB's announcement had on EM currencies was dramatic. Unless EM governments can arrest the decline, Thursday's move could have big implications for stocks in North America as well. In Thursday's Daily Market Commentary webcast, our analyst explained why this relationship exists and how it will affect stocks in the United States.
Emerging Markets Are at the Mercy of a Rising Dollar and the ECB Isn't Helping Matters
The ECB announced that quantitative easing will end this year, but they plan to keep rates extremely low for an extended period. I am summarizing a long statement, but those were the key takeaways. The market reacted immediately, and the euro dropped 1.75% against the dollar compared to Wednesday's close. Another way to think about this is that the dollar gained 1.75% in value against the euro.
If the dollar rises in value and we assume nothing else changes, then it is a safe bet that EM currencies will decline. On a day-to-day basis, this usually isn't an issue, however, this is a big problem right now. The EM currency market has been in turmoil for a few months and panicked sellers in Turkey, Brazil, Argentina, etc. are ready to push prices even lower. When the market suffered the shock brought on by the ECB's surprisingly dovish statement, these sellers emerged again after being somewhat quiet over the last two weeks.
There are a lot of problems that can be caused by a rapidly declining currency. For example, in EM economies it is common for businesses to borrow in U.S. dollar terms. That means they have to make their interest and principal payments in dollars that are getting more and more expensive all the time. Take the Argentine peso: including Thursday's decline, the peso is down 42% since the beginning of the year. Business borrowers are paying nearly double the interest payments they were in January.
Besides the companies within an EM economy, large multinationals also tend to suffer when EM markets are falling because their international operations aren't as profitable. For investors focused on U.S. stocks, this means that small caps (mostly domestically focused) are expected to continue outperforming the large firms in the S&P 500.
The largest emerging markets equities ETFs by total assets are the Vanguard FTSE Emerging Markets ETF (VWO), the iShares Core MSCIEmerging Markets ETF (IEMG) and the iShares MSCI Emerging Markets ETF (EEM).