With more investors feeling optimistic about the health of the global economy, the case for adding emerging market (EM) stocks to your portfolio is growing stronger. Let’s take a look at the biggest risks, and the places where you might find the best emerging market stocks.
What’s the reason to buy EM stocks now?
Investors are increasingly expecting a “soft-landing” scenario for the global economy. That’s the dream scenario where central banks hike interest rates just enough to bring sky-high inflation back down to the ground, without crashing the global economy in the process. If they can manage it, global financial conditions will get a bit easier again and some of the flex in the US dollar will start to fade. And while almost all stock markets would do well in this environment, those in emerging markets would likely profit disproportionately.
That’s in large part because many EM countries are “net exporters” – i.e. they sell more goods abroad than they import – and when their customers across the global economy are doing well, they do really well. But it’s also because investors tend to turn to emerging economies in good times, seeking higher returns by investing in their economies, stock markets, and currencies. Those investors benefit from strong earnings growth, rising valuations, and the strengthening currency. But there’s also a currency benefit for EM economies: as the greenback weakens, the fortunes of EM governments and companies improve, because the money they owe is usually priced in dollars, meaning they can pay that money back – and finance future growth – at a discount.
Over the longer term, the opportunity looks even more attractive: valuations of emerging markets stocks are extremely cheap compared to those of the US stocks, and they’re likely to see more growth. And even if they don’t, they’d still probably add some diversification benefits to your portfolio and could improve its risk-adjusted returns.
What should you look for?
Most retail investors invest in emerging markets through a passive ETF like the iShares MSCI Emerging Markets ETF (ticker: EEM, expense ratio: 0.68%), or the Vanguard FTSE Emerging Markets ETF (VWO, 0.68%). The issue is, these ETFs aren’t really diversified, and much of their exposure comes from China, Taiwan, and South Korea. And while there’s a case to be made for investing in those three larger, more developed economies, they are more exposed than some of their peers to these considerable short-term risks:
First: inflation risk. Inflation might not fall as far or as fast as expected, and that could mean that the US Federal Reserve will continue its aggressive rate-hiking campaign for longer. In that scenario, emerging market countries that haven’t yet hiked aggressively may find themselves with a lot of catching up to do, which could curb their growth. And if inflation is caused by rising commodity prices, countries that rely on commodity imports are likely to suffer. In that environment, China, Taiwan and South Korea are likely to underperform.
Second: global recession risk. It may be too early to count on that soft-landing scenario and assume that the global economy will avoid a recession. Rate hikes don’t slow the economy all at once: it happens over time, hitting one part of the economy after another. Heavy exporters like China, Taiwan and South Korea are likely to struggle should global demand fall.
Third, China-specific risk. Over the long term, owning Chinese stocks makes sense, but there are considerable risks to keep in mind. It’s got a slowing economy and a serious crisis in its property sectors, and rising geopolitical tensions with Taiwan and the US have seriously increased the probability of something going very wrong.
What EM economies look good right now?
You might want to own Chinese stocks, and that’s fine. They’re still attractively priced, but their downside risks have increased since that article was published so I’d consider keeping your allocation on the small side. Instead, look for stocks that would benefit from a rebound in growth, but that have relatively little exposure to China, strong domestic growth, less reliance on the global economy, higher resilience to commodity price swings, and an interest rate buffer that would allow them to cut rates if necessary. And, since no country can currently tick all those boxes, here are the three that come pretty close:
Brazil: Brazil has low exposure to China, is a net beneficiary of higher commodity prices, and has interest rates that could be lowered if the economy started to struggle. What’s more, its domestic growth has been supported by a strong fiscal stimulus, and its inflation has been decelerating. Oh, and Brazilian stocks are extremely cheap right now, both compared to other emerging markets and compared to their own history. Of course, the election in October might add some short-term volatility, but the results aren’t expected to shake up the country’s long-term outlook.
India. If there’s one country full of exciting domestic growth opportunities, it’s India. The government’s ambitious economic reforms should help the country capitalize on the digital revolution and its next stage of growth. Like Brazil, India isn’t overly exposed to China, and it has an interest rate cushion. Unlike Brazil, however, India’s stock market is quite expensive, its currency is showing signs of weaknesses, and its central bank might have to hike rates further to bring down inflation. Nonetheless, India’s stocks are arguably among the most exciting in emerging markets.
Indonesia. This country’s made ambitious economic reforms since the pandemic, and seems well placed to benefit from further easing of Covid measures, which may boost tourism in the country. The government is also attracting a lot of foreign direct investment, and both domestic growth and exports have been very strong. Inflation is still high though, and that may force the central bank to hike rates more aggressively. Indonesia would be negatively impacted by a slowdown in China and by falling commodity prices, but the domestic growth outlook still makes it a much more interesting bet than others.
You can invest in Brazil via the iShares MSCI Brazil ETF (ticker: EWZ, expense ratio: 0.57%), in India via the iShares MSCI India ETF (INDA, 0.69%), and in Indonesia via the iShares MSCI Indonesia ETF (EIDO, 0.57%).
Remember, none of these economies would be immune to a slowdown in global growth or a further tightening of monetary conditions – and those are both significant risks. But for investors with a long-term horizon, adding EM stocks to your portfolio – perhaps by rotating some of your US stocks into them – may arguably improve your portfolio’s risk and returns. And if you use dollar-cost averaging to spread out your entry points, you might even catch a bargain…
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