4 Big Concerns for Emerging Markets
Not too long ago, emerging markets were a no-brainer. Yes, they were volatile, but the long-term trend was so powerful that investors who were willing to put up with the inevitable short-term selloffs could almost be assured of making money.
See Also: Emerging Markets Special Report
I'm still bullish on emerging-markets stocks, but I'm a nervous bull. One thing is for sure: The easy money has been made. Below are my four big concerns, followed by advice about what to do now.
China is the 800-pound gorilla of the developing world. It's the world's second-biggest economy, after the U.S., and accounts for about one-fifth of the stock-market value of emerging markets. Unfortunately, the gorilla is off its feed. The Chinese government claims that the economy is growing about 7.5% a year. But G. Rusty Johnson III, co-manager of Harding Loevner Emerging Markets (symbol HLEMX), says the figure is overstated. In truth, no one knows how fast the sprawling economy is growing. Clearly, though, property values are falling, and that's hurting China's banks.
China is also undergoing a messy, albeit essential, transition from a manufacturing and exporting machine to a more balanced economy. That means more consumer products and services, including health care, for its burgeoning middle class. But it also means slower growth.
The world's appetite for many basic materials is depressed, hurting many commodity-rich emerging countries, such as Brazil, the second-largest emerging economy, after China. Slackening demand from China is the biggest reason, but the fracking boom in the U.S., which is leading to surging production of natural gas, is helping to depress energy prices. Almost one-fourth of the market capitalization of emerging markets is in the stocks of basic-materials and energy producers — and that doesn't include the many government-owned oil companies.
Consider the biggest emerging economies. The Chinese government owns all or most of many big businesses, and puts its thumb on other industries. In Brazil, the government has adopted more pro-consumer policies, such as forcing banks and privately owned utilities to reduce their charges. India has historically suffered from an incredibly meddlesome bureaucracy. It's interfering with the coal industry, infrastructure construction, telecom and utilities. These headwinds, plus inflation, are major problems. "You can't grow an economy if you can't keep the lights on," Johnson says. Russia, of course, has virtually no experience with a real market-based economy and defaulted on its debts in 1998.
Emerging-markets stocks suffer from excessive expectations. For years, the profits rolled in. Over the past ten years, the MSCI Emerging Markets index returned an annualized 16.8% — more than double the return of Standard & Poor's 500-stock index. But this year, the MSCI index has shed 3.4%, while the S&P 500 has returned 9.7%. A March survey of fund managers by Bank of America Merrill Lynch found that only 14% now expect the Chinese economy to strengthen in the coming 12 months — an abrupt reversal from previous monthly surveys. (All returns are through March 22.)
Despite the headwinds, emerging markets look reasonable to me, especially given their still-superior growth prospects. The MSCI index trades at 11 times estimated year-ahead earnings. The index sells at less than one times sales, 1.5 times book value (assets minus liabilities) and less than 5 times cash flow (earnings plus depreciation and other non-cash adjustments). Plus, the index yields 2.9%.
All of those numbers are appealing. But the index is cheap partly because of its big weighting, compared with developed markets, in beaten-down commodity stocks, which have been lousy performers in recent years. By contrast, many consumer stocks are trading at relatively high valuations.
I wouldn't avoid emerging markets. Given the attractive valuation, I think investing 10% to 15% of your stock money in emerging countries makes good sense. I would steer clear, though, of funds that are dedicated to "frontier markets" — those that invest in less-developed emerging countries. In my view, they're simply too risky.
Picking a fund poses a dilemma. The best actively managed, open, no-load offering I can find is the Harding Loevner fund. But it charges high annual expenses of 1.49% and has only matched the MSCI index over the past ten years, albeit with slightly lower volatility. The Vanguard FTSE Emerging Markets ETF (VWO), an exchange-traded fund with an annual expense ratio of 0.18%, is, I believe, a better choice.
The best bet, in my view, is the WisdomTree Emerging Markets Equity Income ETF (DEM), which weights stocks based on dividend payout. Over the past five years, the ETF returned an annualized 5.5%, compared with 2.0% for the index. Yet it has been 10% less volatile than the benchmark. Annual expenses are 0.63%.
Steve Goldberg is an investment adviser in the Washington, D.C., area.