Emerging market stocks and bonds have continued to under perform their Developed Market counterparts through the first month of 2014. Recently, this underperformance has become a hot topic in the financial media, with a variety of opinions being expressed, including the always-popular (and often incorrect) buy/sell/hold predictions.
Emerging Markets, Defined
Emerging markets are ones that generally do not have the level of market efficiency and strict standards in accounting and securities regulation to be on par with developed economies (such as the US, Europe and Japan), but emerging markets will typically have a physical financial infrastructure including banks, a stock exchange and a unified currency. Emerging markets are sought by investors for the prospect of high returns, as they often experience faster economic growth. But, investments in emerging markets come with much greater risk.
For the majority of individual investors, emerging markets represent the most aggressive allocation in their portfolio. This volatility is due to a few reasons:
Large emerging market investments are usually made in the country’s local currency, which must be exchanged with the Dollar or Euro at some point. Significant interest or exchange rate movements can and do effect the investment return. Additionally, local infrastructure and political processes can be inefficient or corrupt, with investment requiring a multi-year or multi-decade time period. Finally, emerging market economies are closely tied with their developed market financiers. In our current economy we see that bond in the form of commodity prices. Weakness in commodity prices in developed markets is negatively impacting emerging market countries like Russia and Brazil, who are net supplies of commodities.
The Current Situation
Our current global economic environment pulls all of these elements together into what some have called a “Perfect Storm.” Media suggestions have ranged from “buy all that you can” to “the asset class is structurally broken.” In reality, neither extreme is ever correct and the truth lies somewhere in the middle.
For the first time in a decade, interest rates are on the rise. The rate situation in the US and abroad is to blame for a part of the recent emerging market volatility. As US rates dropped to generational lows, investors became “yield-starved;” seeking the comfortable four, five and six percent yields of decades past. They piled into increasingly risky, higher yielding investments. Emerging markets offered these yields, and their price increased correspondingly. That tide has now turned and money is flowing out of the riskier emerging market investments into safer developed market investments.
As one can imagine, interest rate turmoil in the U.S. and abroad has led to volatile foreign exchange rates globally.
As the largest emerging market, and second largest single economy by GDP, China is an important bellwether of overall emerging market strength. Recent weakness in Chinese credit, wealth management products and manufacturing data have reignited concerns of a Chinese “hard landing” or recession. Additionally, China is the largest purchaser of commodities globally; reduced purchases would have a contagion effect on other emerging markets. While there are concerns related to China’s consumer credit and shadow-banking sectors, China has taken steps to liberalize its interest rate controls, a recent positive development.
In light of the recent weakness of nearly all emerging market investments, investors would be wise to consider the performance of other elements of their portfolio. Domestic and International developed market equities have performed well, offsetting emerging market losses in well-balanced portfolios.
Emerging markets are currently undervalued. But, we would expect weakness to continue in the short-term. Longer-term, we feel Emerging Markets offer a compelling value, with proper due diligence