Keep a small stake but brace for a bumpy ride. Strategist Michelle Gibley says emerging-markets stocks won't take off until more nations address their structural problems. Benjamin Ramussen By Carolyn Bigda, Contributing Writer From Kiplinger's Personal Finance, May 2014 The case for investing in emerging markets is being put to the test. China’s economic growth is slowing. Countries such as Thailand, Turkey and Ukraine are in the throes of political unrest. The Federal Reserve’s plan to scale back its bond-buying program is causing currencies to plunge in places such as Brazil and Indonesia. The turmoil is taking its toll. Over the past year through March 7, a period of strong gains for U.S. stocks, the MSCI Emerging Markets index lost 6.0%.See Also: The Kiplinger 25 With all of this turbulence in mind, we asked Michelle Gibley, director of international research at the Center for Financial Research at Charles Schwab & Co., to give us her take on what’s ahead for developing economies—and what investors should do. Below is an edited version of the interview. KIPLINGER: What explains the poor performance of emerging-markets stocks recently? GIBLEY: A confluence of events is going against emerging markets. The Fed’s tapering is likely to push up Treasury bond yields and make the dollar more attractive to investors. That’s hurting the currencies of nations with large current-account deficits [countries that spend more than they save], resulting in higher inflation and causing their central banks to tighten monetary policy. And structural issues in the largest countries within the MSCI Emerging Markets index—Brazil, India, Russia and China—are causing slower economic growth. Advertisement Should investors expect a selloff in emerging-markets stocks every time the Fed hints at increasing rates? A lot of the countries that are most at risk—the so-called Fragile Five of Brazil, India, Indonesia, Turkey and South Africa—have already taken steps to reduce speculation against their currencies by raising interest rates or by intervening in the currency markets. Brazil has increased its interest rate eight times in the past year. So I think the big wave of tightening could be pausing. But head winds to growth will remain this year. All of the Fragile Five countries will have elections in 2014. What do you see coming out of them? Going into the elections, spending on populist measures is likely to increase, and that could worsen the Fragile Five’s financial positions. Those countries will have to raise money by issuing debt at potentially unfavorable interest rates. They’ll also have more debt in the future, which will weigh down growth. So until we get through the elections, we see few positive reforms coming out of the Fragile Five. Advertisement Have any countries made the structural changes that are needed? China is one of the few countries actually taking steps to restructure its economy. Last fall, it announced a series of reforms that could set the stage for more-sustainable growth. Local governments in China, for example, have been responsible for 80% of spending but have gotten only about half of tax revenues. That has put those governments—the biggest clients of Chinese banks—in a weak financial position. How will reforms affect Chinese stocks? Chinese stocks are pricing in a lot of bad news. They’re undervalued relative to other emerging-markets stocks because investors are worried about slower growth. But China’s double-digit growth rate was not sustainable when it was propelled by massive amounts of debt. Now, the country is trying to transition away from that toward growth driven by consumption. Growth will be slower but also more sustainable, and that should make Chinese stocks attractive. Advertisement Strategist Michelle Gibley on emerging markets. Benjamin Ramussen When would you expect that to happen? It’s possible that it could happen over the next year. All of the reforms do not have to be enacted for Chinese stocks to improve. Think about what happened with Japan just over a year ago. Japanese stocks began to rise well before the country’s central bank started to increase its quantitative-easing [or bond-buying] program. The market only needs to see movement toward reform and to believe the government is going to stick with it. Will that help lift emerging-markets stocks overall? China matters the most for emerging markets. It makes up 20% of the MSCI Emerging Markets index. But as I mentioned, China’s economy is transitioning away from infrastructure spending and toward consumer spending. So its stock market could become less correlated to emerging-markets countries that are primarily commodity exporters and that are still tied to China’s old economic model. China’s reforms will benefit Chinese stocks more than the overall emerging-markets category. Advertisement So should investors tilt their portfolio toward China? Or should they get out of emerging-markets stocks altogether? At this point, I do like China over the broader group, but for most people the best way to go is to use a broad emerging-markets mutual fund or exchange-traded fund. Investing in individual countries requires more research and monitoring than most people are able to do. Longer term, the outlook for emerging markets is bright. They have higher growth opportunities than developed markets, as incomes rise and as more of their citizens enter the middle class. That said, now is not the time to load up on the category. The stocks may appear inexpensive today, but until more countries begin to address their structural issues, low prices alone may not be enough to support a sustainable rebound. Investors should stick to a weighting in emerging-markets stocks that’s in line with their long-term asset allocation. Most investors should have 25% of their stock portfolios in foreign stocks, and of that, 20% should be in emerging markets. How should investors react to political crises that erupt in emerging markets, such as the one in Ukraine? The potential for higher risk, including political crises, is an aspect of investing in emerging markets. This is the reason we advocate using diversified funds that invest across countries and sectors when investing in emerging markets. Using a diversified approach within a longer-term time horizon can help insulate investors from overreacting to emotional events.