As I’m a holiday this week, I have a short note today…on emerging markets! I admit that I have been a little too optimistic about prospects for EM equities over the last few years. Cynics would, of course, argue that it was obvious emerging markets would take a hit as US interest rates increased and the Fed tightened liquidity i.e typical late cycle financial dynamics. I, by contrast, have argued that growth in many emerging markets was strong and that a great many local equities represented great value. I’ve been proved wrong and now we face the inevitable reckoning. The name of the game now, I suppose, is to avoid those nations likely to be hardest hit – places like my own favourite, Turkey.

Last week SocGen analyst Jason Daw provided a useful quick summary of the countries to watch. In a note entitled EM Looking Glass – Who’s Naked, Daw observes how the tide (of cheap dollar funding) is receding and aims to identify those countries which have been, or will be, caught “naked”. Here’s Daw’s take:

The misallocation of capital following a decade of cheap money is starting to be exposed. Coupled with high dollar liabilities, the scale of which has not been tested in a Fed tightening cycle, will lead to periodic episodes of stress. At a minimum, higher dollar funding costs will make investors more selective in their choice of risk assets.

To assess vulnerabilities across emerging markets, we examine external positions, short-term external debt, foreign currency-denominated debt, fiscal and debt positions, reserve adequacy, and foreign bond ownership. A scorecard of gross (i.e. total number of indicators that suggest high vulnerability) and net (the summation of negative, neutral, positive vulnerability factors) vulnerabilities sheds light on which currencies might experience additional stress as the Fed continues to tighten monetary policy or if other factors impair EM sentiment.

High vulnerability: Turkey, South Africa, Malaysia, India, Indonesia.
Medium vulnerability: Mexico, Chile, Brazil, Colombia, Czech Republic, Hungary, Poland.
Low vulnerability: Korea, China, Thailand, Russia