By Dan Weil
After a torrid two-year rally in emerging-markets stocks and
bonds, the gut reaction of investors might be to pull back. After
all, rising U.S. interest rates and a possible trade war, combined
with the run-up of the past two years, would seem to work against
the investments moving forward.
But many investment strategists say that long-term investors,
including those tending to their 401(k)s, should fight their guts.
They recommend against reducing your holdings in the stocks and
bonds of such countries, which include such growing but
still-riskier economies as China, South Korea, Taiwan, India and
Brazil.
Their bottom line: It's still generally wise to have 5% to 10%
of investment assets constantly allocated to such markets.
"There are a lot of moving parts" to interest rates and trade,
says Alex Bryan, director of passive-strategy research at
investment-information firm Morningstar. "It's hard to predict how
they will unfold. You shouldn't time the market based on events."
The best strategy, he says, is to maintain a diversified portfolio
-- and emerging-markets investments can play an important role in
that respect.
The past two years have been excellent for emerging markets. The
MSCI Emerging Markets Stock Index soared 44% during that period,
while the Bloomberg Barclays Emerging Market Local Currency
Government Bond Index climbed 19%.
Some experts worry that the good times will end as the U.S.
Federal Reserve continues to raise interest rates and trade
conflicts brew. The argument is that higher rates in the U.S. and
other developed nations make their investments, particularly bonds,
more attractive than those in emerging markets.
In addition, rising U.S. rates can push the dollar higher,
making shares of foreign stock and bond funds worth less in dollar
terms.
What history says
Still, research shows that in the previous four cycles when the
Fed increased rates, emerging-markets stocks outperformed the MSCI
All Country World Index in three of them, says Michael Sheldon,
chief investment officer at RDM Financial Group in Westport,
Conn.
The idea that rising U.S. rates hurt emerging markets applied
more in the late 1990s, "when developing economies were in some
sort of disarray, " says Karim Ahamed, investment strategist at HPM
Partners in Chicago. "But that has changed since the financial
crisis. Over time, a lot of these economies have straightened out."
Now, many emerging-markets economies have lower debt-to-GDP ratios
than the U.S. and Japan, Mr. Ahamed says.
Developing nations benefit from younger populations than their
developed brethren, a rapidly growing middle class and a shift away
from manufacturing toward more consumer-based economies. Emerging
markets now account for 40% of world GDP, and economists expect
that percentage to rise rapidly.
In any case, some say emerging markets will suffer less than
developed markets as rates increase. "Developed stocks markets
could actually be more vulnerable," says Jack Ablin, chief
investment officer at Cresset Wealth Advisors in Chicago. That is
because it is mainly central banks in developed economies that are
increasing rates, which can damp a country's economic growth,
thereby depressing corporate earnings.
In addition, despite the rising-rate environment, U.S. rates
remain well below historical averages, Mr. Sheldon notes. So the
ascent of U.S. rates might not have a major impact on emerging
markets.
"If rates rise more slowly than expected, it might not hurt
emerging-market stocks at all," Morningstar's Mr. Bryan says. "I
wouldn't make a tactical adjustment [to emerging-markets
allocations] based on interest rates." Fed officials have indicated
they expect to raise rates another two or three times this
year.
When it comes to potential trade tussles, the argument is that
emerging markets would endure the most pain because many developing
economies are dependent on exports. But Mr. Ahamed points out that
the dependency has lessened as many of these nations begin to shift
their emphasis to internal consumption. And in any case, at this
point, it looks like trade spats will have a more bilateral focus,
such as the U.S. vs. China, than world-wide, he says.
The tariffs announced by President Donald Trump in March apply
only to steel and aluminum, Mr. Bryan notes.
"It's unclear whether they will be extended beyond that and how
countries will respond," he says. "It's hard to forecast their
impact on emerging markets."
Investors shouldn't base their allocations on uncertain
developments, many expert say. "It's noise," Mr. Bryan says. "The
best course is to be diversified and maintain a long-term strategic
allocation."
Still looking cheap?
As for stock valuations, now is actually a good time to build an
exposure to emerging markets, because they look relatively cheap
despite the run-up, strategists say. Emerging markets have a
forward price-to-earnings ratio of 12, compared with 17 for the
U.S. and 16 for the world as a whole, according to MSCI and J.P.
Morgan.
"Emerging-market stocks are now priced attractively," Mr. Bryan
says.
Emerging-markets stocks account for 8% of world stock-market
capitalization, which is largely why he and others in general
recommend a 5% to 10% equity allocation for emerging markets.
Two funds Mr. Bryan recommends are iShares Core MSCI Emerging
Markets ETF (IEMG) and iShares Edge MSCI Min Vol Emerging Markets
ETF (EEMV). Both are well diversified.
The first has an annual expense ratio of only 0.14 percentage
point and holds stocks of all sizes. The second is designed to be
more risk-averse; it excludes small-capitalization stocks and
generally seeks to reduce volatility.
Bond yields beckon
On the bond front, Mr. Ahamed finds emerging markets attractive,
too. Yields there are higher than in developed markets. For
example, Vanguard Emerging Markets Government Bond ETF (VWOB)
yields 4.7%, compared with 2.73% for Vanguard Long-Term Treasury
ETF (VGLT).
The solid fiscal health of many emerging markets also buoys
their bonds, Mr. Ahamed says. And many emerging-markets central
banks have the capacity to cut interest rates if their economies
slump. That would boost their bond prices, benefiting
bondholders.
Mr. Ablin agrees with Mr. Ahamed that emerging-markets bonds are
attractive, but he doesn't recommend a constant exposure to them
like he does to emerging-markets stocks. That's because he invests
in bonds for safety, and emerging-markets bonds generally aren't as
stable as those in the U.S.
"I use bonds as a source of a specific cash flow at a specific
date," Mr. Ablin says. "From that perspective, it's still uncertain
whether emerging-market bonds deserve a seat at the table."
His base case is zero allocation to emerging-markets bonds, but
at times like now when they're attractive, he recommends that 5% to
10% of a bond portfolio be allocated to emerging markets. "If the
emerging-market bond market deteriorates relative to U.S. bond
markets," Mr. Ablin says, he will reduce the allocation again.
Mr. Weil is a writer in West Palm Beach, Fla. He can be reached
at reports@wsj.com.
(END) Dow Jones Newswires
April 08, 2018 22:29 ET (02:29 GMT)
Copyright (c) 2018 Dow Jones & Company, Inc.
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