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Emerging Markets: Why They Deserve a Place in Your Portfolio

Key Points
  • Emerging market (EM) economic and corporate earnings growth could accelerate in 2017, and trade may prove more resilient than some expect.

  • Emerging market exports may benefit from acceleration in the U.S. economy but a sharply higher U.S. dollar could limit stock market gains.

  • We suggest investors keep their EM stock allocations in line with their long-range targets.

Emerging market (EM) stocks were having a pretty good year until the U.S. presidential election. The MSCI Emerging Markets Index was up nearly 14% for the year as of Election Day, only to tumble almost 7% in the week after. The index has recovered some of its lost ground since then, but that bout of volatility may have raised some questions. 

At issue here are concerns about what sort of policies the administration of President-elect Donald Trump might enact. Some of the proposals made during the election campaign suggested the U.S. could erect barriers to trade and adopt fiscal and tax policies that could spur inflation. The concern is that such policies could pose challenges for emerging markets by hurting trade, soaking up capital as U.S. interest rates rise and making emerging market borrowers’ dollar-denominated debt more costly should the dollar continue to strengthen.

However, we don’t think this means investors should avoid EM stocks or change their long-term allocations to this asset class. As we enter 2017, the prospects for both stronger economic and earnings growth in emerging markets may improve and trade may prove more resilient than expected. That said, a sharply stronger dollar could weigh on returns. Taken together, we wouldn’t suggest investors change their allocations.

Economic and earnings outlook for EM is improving

The International Monetary Fund expects economic growth in emerging markets to accelerate to 4.6% in 2017 from 4.2% this year and 4.0% in 2015. (The projected improvement this year would mark the first gain for emerging markets in six years.)

As the chart below shows, several leading indicators of economic activity have been improving over the past year.

Source: FactSet and Markit, as of 12/9/2016. Purchasing managers indexes (PMIs) are economic indicators derived from monthly surveys of private sector companies.

Improving growth prospects in the U.S. could also be good for emerging markets. The Organization for Economic Co-operation and Development (OECD) said after the election it expects the U.S. economy to grow 2.3% in 2017, faster than the 1.5% expansion it sees in 2016. Consumer spending drives U.S. growth, and much of that spending is on imports, so any rise in the U.S. tends to be good news for emerging market exports. The IMF expects global trade volumes to grow 3.8% in 2017, representing a 1.5 percentage point improvement from 2016.

The renewed global focus on infrastructure spending, including in the U.S., could sustain or lift commodity prices, which tend to correlate closely with gains in EM stocks.

Improving growth should also be good for corporate earnings. Ned Davis Research expects earnings for the MSCI Emerging Markets Index to improve from –6.2% over the past twelve months to a positive 12.9% in the next twelve months.2

Trade may surprise naysayers

While a turn toward protectionism in the U.S. could pose a risk to emerging market economies, it’s important to keep this in perspective. First of all, it’s uncertain whether Trump will be as protectionist as a president as he was on the campaign trail. Even if he were to adopt more trade tariffs, it’s possible a deal-maker like Trump would use them as a short-term negotiating tactic while hammering out new terms with the U.S.’s trading partners.   

Trump also appears to favor some countries more than others, so the effects of increased protectionism toward one country could be offset by increased openness toward another country. For example, if the U.S. were to erect barriers to trade with Mexico and lower barriers to trade with Russia, the effects could balance each other out as each country makes up roughly 4% of the MSCI Emerging Markets Index.

Trump does seem to favor a more antagonistic line toward China, which could be a concern for investors in EM stocks since that country accounts for more than 27% of the MSCI Emerging Markets Index. However, the effects of U.S. protectionism could be limited.

China’s exports to the U.S. are equivalent to only 3.7% of its gross domestic product,3 and it looks set to continue seeking out trade deals with other countries even if the U.S. takes a step back from global trade. China wasn’t a member of the Trans-Pacific Partnership (TPP), a regional trade deal that included the U.S. and may now be dead, but it is a member of the Regional Comprehensive Economic Partnership Agreement (RCEP), a deal still under discussion that could lower barriers between China, India, Japan, Australia, and the 10 members of the Association of Southeast Asian Nations (ASEAN), as well as other countries in the region.

A rising U.S. dollar could pose challenges

Concerns that emerging markets could also face challenges from a rising U.S. dollar should also be considered in context. One big concern here is that in the past, a stronger dollar and rising interest rates have tended to draw money out of capital-hungry emerging countries and into the U.S. Some emerging economies suffer from low savings rates, so they rely on foreign capital to make investments in their productive capacity. When foreigners pull their money out to chase higher yields in the developed world, growth in emerging economies can suffer.

We saw this dynamic play out in the 1997 Asian financial crisis. In 1997, the top three countries in the MSCI Emerging Markets Index were Malaysia, Brazil and South Africa. All three countries had negative current account balances, partly because they were taking in more money from investors than they were earning from net exports. When those capital flows reversed in response to rising U.S. interest rates, those economies suffered.

However, much has changed since then. Now, the top three countries in the MSCI Emerging Markets Index are China, South Korea and Taiwan. All three countries have current account surpluses, as do several other index heavyweights.

EM stocks less vulnerable to dollar than in past

Countries
(top weights)
 

EM stocks weight

Current account balance in 2015

Current account balance in 2012

Current account balance in 1996

China

27.6%

3.0% 

2.5% 

0.8%

S. Korea

14.6%

7.7%

4.2%

-3.9%

Taiwan

12.5% 

14.6%

8.8%

3.7%

India

8.2%

-1.1

-5.0%

-1.5%

Brazil 

7.8%

-3.3% 

-3.0%

-2.7%

S. Africa

6.8%

-4.4% 

-5.1%

-1.1%

Russia

3.9%

5.2%

3.3%

2.8%

Mexico

3.5%

-2.8%

-1.4%

-0.6%

Malaysia

2.5%

3.0%

5.2%

-4.4%

Indonesia

2.5%

-2.1%

-3.2%

-3.4%

Thailand

2.2% 

8.0%

-0.4%

-8.0%

Source: MSCI, World Bank, Bloomberg as of 11/30/2016.

There are also concerns that a rising U.S. dollar and interest rates could make it more expensive for emerging market borrowers to roll over their dollar-denominated debt. And, as mentioned above, a stronger dollar could depress returns from EM stocks.

However, it’s important to note that rising rates on their own aren’t automatically a bad thing for emerging markets. For example, if interest rates rise because growth is picking up in the U.S., emerging markets could see their exports grow enough to more than offset potential changes in financial flows. A stronger dollar could also make their exports look even cheaper.

Takeaway

All things considered, emerging economies could see their growth prospects improve, even as they grapple with a potential rise in protectionism and a stronger dollar. We feel these factors could balance each other out, so we don’t suggest investors adjust their long-term allocations to EM stocks.

Investors who are overweight on emerging markets should consider trimming their exposures back to neutral, while those who are underweight should consider increasing weights back to long-term strategic targets. Returns in 2017 could be volatile, but emerging economies are attractive over the longer-term due to their higher growth prospects and a growing middle class. We don’t suggest investors wait until volatility risks fade as timing the market is difficult.

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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

International investments are subject to additional risks such as currency fluctuation, geopolitical risk and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

The MSCI Emerging Markets Index captures large- and mid-cap representation across 23 emerging market countries. With 832 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

(1216-S44W)

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