In Friday’s Daily Market Commentary webinar, we received several questions about why emerging markets stocks and funds had performed so poorly. The answer may sound odd, but the relationship between financial troubles in Europe and emerging market stocks is important to understand.

Fears of a New Euro Crisis May Send Investors Out of EM Stocks

A new coalition government in Italy has investors a little on edge if they follow through on plans to cut taxes and increase fiscal spending against the wishes of the EU. Following the news, yields in Italy were higher, and the dollar continued to attract buyers looking for a safe-haven. The problem for emerging markets is caused by two main factors. First, a rising dollar tends to accelerate capital flows out of emerging markets, which causes inflation. Second, if yields rise in Europe, then bonds and debt in emerging markets is less attractive, which drives up borrowing costs.

Weakening currencies and rising interest rates in emerging markets will likely have a direct negative impact on emerging market stocks and funds like the iShares MSCI Emerging Markets ETF (EEM) or the Vanguard emerging markets ETF (VWO). You don’t have to look much further than the reaction in EEM during the Greek financial crisis of 2012 (below) to see how bad the problem could get if it escalates.