How to Invest in Emerging Markets in 2016

ChinaEmerging markets continue to give stock investors fits. The MSCI Emerging Markets index, representing markets in 23 countries, has plunged 29% since late April 2015. And the pain may not be over. “The perfect storm that has hit emerging markets in the past two years has become even more perfect,” says Nariman Behravesh, chief economist at IHS Inc., a business-consulting firm.

Start with the slowdown in China. The world’s second-largest economy expanded by 6.9% last year (its slowest growth rate in a quarter-century), and IHS expects growth to decline to 6.3% this year and in 2017. “Slowing growth in China will by default slow everything else around it,” says Christopher Wolfe, a strategist at Merrill Lynch Wealth Management.

Plunging commodities prices are a huge problem. The IHS Materials Price index is at its lowest level since December 2003, spelling disaster for such exporters as Brazil, Russia and South Africa. Currencies of troubled countries have collapsed as confidence in their economies has flagged. Cheaper currencies can help struggling economies by making exports more attractive. But the declines are also a sign that investors are cashing in their chips. The Institute of International Finance estimates that net capital outflows from emerging markets soared from $111 billion in 2014 to $735 billion last year.

On top of everything else, a dangerous debt bubble is forming. Borrowing, by both governments and companies in the private sector, exploded in the developing world after the Great Recession. In China, for example, the ratio of debt to gross domestic product has more than doubled since 2007, to about 280% last year.

For investors, the key question is whether stock prices already reflect all the bad news. The MSCI Emerging Markets index sells for 10 times estimated 2016 earnings. That compares with 14 for the MSCI EAFE index, which tracks stocks in developed foreign markets, and 16 for Standard & Poor’s 500-stock index. GMO, a Boston investment firm, says that emerging-markets stocks are cheap and believes the group will return an annualized 4% after inflation over the next seven years. By comparison, GMO expects U.S. stocks to lose 1.8% after inflation over the same period.

Even with all of the problems in developing markets, there are some bright spots. The slowdown has had little effect on India’s service-driven economy, and Mexico will prosper because of its proximity to the U.S. Markets on Europe’s periphery could do well as the economies of developed Europe rebound.

Investors with a long-term outlook should not ignore such a large part of the global economy, but for now the weight of the evidence demands caution. For clients with moderate-risk portfolios, that means no more than 5% in emerging-markets stocks, says Merrill Lynch’s Wolfe.

Your best bet is to tackle this corner of the investment world with a professionally managed fund. Harding Loevner Emerging Markets Portfolio (symbol HLEMX), a member of the Kiplinger 25, is a good choice. James Syme, manager of JOHCM Emerging Markets Opportunities (JOEIX), another solid fund, skirts the diciest markets in favor of India, South Korea, Taiwan and China. “Stocks like Taiwan Semiconductor or Kia Motors benefit from recovery in Europe and a strong U.S. economy,” he says.

Hedging against currency swings can be counterproductive over the long haul. But those who expect the greenback to continue to strengthen should consider iShares Currency Hedged MSCI Emerging Markets ETF (HEEM).

(Source: TCA)