Emerging market stocks have been on a tear lately, and some say the rally could continue, but there are reasons to be cautious. Anyone wanting to invest in the sector should understand the risks and potential rewards.
The MSCI Emerging Markets index, which tracks stocks in a variety of emerging market countries, has shot up more than 10 percent this year versus where it ended last year.
That’s a sizable move, especially when an annualized stock return of 10 percent is considered healthy, never mind such a move in less than two months. Will it continue? Maybe not.
[See: 10 Great Ways to Buy Emerging Markets.]
King dollar. The major problem is the strength of the U.S. dollar. It has surged over the past few years and in doing so has hurt emerging market economies in a couple of ways. Worse still, the currency is likely to gain some more.
First, a strong greenback crushes the prices of commodities on which many emerging markets rely on for export earnings. Commodities are all denominated in dollars, so they tend to get pushed down in price as the dollar goes up.
Second, a strong dollar tends to attract capital and investment away from emerging market countries. Any country that loses capital tends to grow more slowly than it would with the investment. So when capital leaves emerging economies and comes to the U.S., America gains and the other countries lose.
The trade-weighted dollar index against major currencies has rallied approximately 38 percent since the low of May 3, 2011, according to data from the Federal Reserve Bank of St. Louis. It is likely to go even higher later this year when the Fed raises the cost of borrowing. Investors who look for higher yields on bonds will be more attracted to dollar-denominated fixed income securities as interest rates move up.
“I’m still sticking with the story that the Fed hikes three times in 2017 and you should avoid emerging markets until the dollar stabilizes,” says Win Thin, global head of emerging market currency strategy Brown Brothers Harriman.
When the dollar stops rising, emerging markets would be less risky.
Less pessimistic views. “We do have an optimistic view of emerging markets and we do think emerging markets will outpace developed markets,” says Jack Ablin, chief investment officer at BMO Private Bank. He does acknowledge the problem with the dollar and says a strong greenback is not in the interest of either the Trump administration or policy makers such as Fed Chair Janet Yellen.
[See: 10 ETFs to Buy for Aggressive Growth.]
Part of the reason BMO has such a positive view on the sector is that the valuation of stocks in emerging markets looks favorable. In a report, BMO Wealth analysts say that international equities, including emerging markets, are the cheapest asset classes on an earnings yield basis. Emerging market stock prices are a better bargain than stocks in the U.S.
There is further good news. BMO Wealth analysts say that agricultural commodities and industrial metals are gaining on increased demand. Any gains in the commodity field tend to help countries such as Brazil and Chile, which are reliant on exports of materials and/or foodstuffs. If the commodity markets do well then many emerging markets do well. Of course, that doesn’t mean that the commodity rally won’t be stymied by another surge in the dollar.
Not all the countries are equal. “The overarching theme is that dispersion has been picking up,” says Alper Ince, sector specialist for Europe and emerging markets for Paamco, an institutional development firm based in Irvine, California. In other words, not all emerging markets present the same opportunities. Some are better than others.
For instance, Ince says it’s probably best to stay away from Chinese state-owned industries. The state-owned enterprises get heavily influenced by local and national communist party edicts, which means that such companies can’t be relied upon to make business savvy decisions.
[Read: Why the Outlook for Emerging Markets Is Improving.]
That said, over the longer-term horizon, Ince likes Chinese companies that specialize in technology, media and the internet.
Meanwhile, in terms of countries, he says India, Brazil, and Russia all look promising, while Turkey is dogged by political instability.
Investments in specific countries can be made directly in the local stock markets, but for most investors, it is less hassle to find country-specific or regional specialty funds.
For India, there is the Wasatch Emerging India Investor (ticker: WAINX), which has annual expenses of 1.82 percent or $182 per $10,000 invested. Russia investors have the VanEck Vectors Russia exchange-traded fund ( RSX), which has annual expenses of 0.67 percent.
More from U.S. News
10 Important Investments Before Having a Baby
10 ETFs to Buy for Aggressive Growth
7 Dividend Stocks to Benefit From Trump Tax Changes
Emerging Markets Are Full of Investing Risk and Reward originally appeared on usnews.com
