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%.
With all of this turbulence in mind, we asked Michelle Gibley,
director of international research at the Center for Financial
& 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.
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.
Have any countries made the structural changes that are
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
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.
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
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
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.