Emerging markets: Potential vs. risks
Joel Dresang: Steve, emerging market stocks showed a positive return in 2016. That was the first gain that they showed in four years. Let’s talk a little bit about that asset class, how it fits into people’s portfolios. But, first, how about a definition of what emerging market means?
Steve Giles: Joel, emerging market stocks are stocks that can be found in countries of developing nations. Those nations are found typically in Latin America, Asia, Eastern Europe and Africa. Compared with the developed nations of the more mature economies, that’s going to be found in places like Western Europe, North America and Japan.
Joel: So, what sorts of characteristics do stocks in those emerging markets have that investors should consider for their portfolio?
Steve: Well, a big difference between the emerging developing nations and the developed nations is that the emerging markets have a much faster growth rate. Keep in mind, their populations are growing at a much faster rate than the developed world, so that’s going to benefit the growth in those economies.
You’re also going to get some geographical diversification that comes with owning markets outside of the developed world.
In addition to that, and this is very important for investors that are building diversified portfolios, is you’re introducing an asset class that what we call in the industry is a non-correlating asset.
Joel: Explain that.
Steve: Non-correlation basically means that you’re introducing certain investments into a portfolio that beat to different drummers. You want to build a mix of stocks and bonds and other assets that all have different benefits. Where one asset class may be going down, you’re going to have the benefit of another asset class that at that time, might be going up.
Joel: So I’m hearing about some potential here for these emerging market stocks. What are some of the risks?
Steve: Well Joel, there’s a lot of risks. Of course, they’re going to be very, very volatile. With the potential for higher growth comes higher volatility. You also have markets that are very commodity driven. And because they’re commodity driven, their success a lot of times is going to be dependent upon whether or not the developed world is experiencing periods of growth or periods of slowdown.
Take for example, what just happened in China over the last decade. Ten years ago, China was growing very, very fast, and the emerging markets were doing very well because of the demand from China for a lot of those basic raw materials that the developing economies can provide. Well, when China slowed down, the ripple effect that it had on the emerging economies was felt around the world.
Joel: What about geopolitical risks and the infrastructures of these countries?
Steve: You know, that’s a great point, Joel. Because of these countries being less developed, there is a lot of geopolitical risk.
I think it’s important to remember that in these countries you don’t have as much transparency as you might have in the developed world. Their markets are a lot harder to monitor, and for that reason, it’s going to be more difficult to track your investments.
Joel: What about currency risks? The dollar is strong right now, how does that affect emerging markets?
Steve: Well Joel, it’s very important to keep in mind that a lot of these local commodities are priced in U.S. dollars. So, when you have an emerging market country that’s exporting basic raw materials priced in U.S. dollars, any increase in the U.S. dollar is going to have a negative impact on their ability to do that exporting in a manner that’s profitable for them. Add to that the possibility that their local currency might go down in value, and now you’ve got a double whammy for a lot of those economies.
Joel: What about the sovereign debt of these countries?
Steve: Joel, a lot of these countries, sovereign debt is linked to the U.S. dollar. So again, here you have a situation where if the U.S. dollar continues to increase, that’s going to have a negative impact on these countries’ ability to pay back a lot of that interest.
Joel: So I’m hearing some potential here from emerging market stocks, but also a lot of risks. How does this fit in a diversified portfolio?
Steve: Well Joel, I think younger investors that have a longer time horizon, investors that might be more tolerant of taking some risks in their portfolio, emerging markets can be a very compelling introduction. However, if you’re retired, if you want income, if you want preservation, emerging markets might not be a good addition. As always, it’s important to know what your time horizon is and your tolerance for risk when you consider adding investments like this to your portfolio.
Shopping for Foreign Stocks? Here Are a Few Things to Keep in Mind, by the Financial Industry Regulatory Authority
Economic SnapChart: Strong Dollar, by Paige Radke
Risk: How much can you stand? How much do you need? a Money Talk Video with Isabelle Wiemero
Talking Money: Emerging markets, a Money Talk Video with Marc Amateis
International Investing, from the Securities and Exchange Commission
(initially posted Feb. 20, 2017)