With more investors feeling optimistic about the health of the global economy, the case for adding a portion of our investment in emerging market (EM) stocks to our portfolios is becoming stronger. Let's take a look at the biggest risks and the best regions where we can place our investment in emerging market stocks.
What is the reason to invest in emerging market stocks now?
Investors increasingly expect a “soft landing” scenario for the global economy. It is the dream scenario in which central banks raise interest rates enough for inflation, which is skyrocketing, to fall again, without the world economy collapsing in the attempt. If they succeed, global financial conditions will ease and some of the US dollar's flex will begin to fade. And while almost all stock markets would perform well in this context, emerging markets will likely benefit disproportionately.
On previous occasions (blue circles) soft landings have been achieved. Source: Market consensus
In large part, this is because many emerging countries are "net exporters." That is, they sell more goods abroad than they import. While their clients are doing well in the global economy, they are doing even better. But it is also because investors tend to flock to emerging economies in good times, seeking higher returns by investing in their economies, stock markets and currencies. These investors benefit from strong earnings growth, rising valuations and strengthening currencies. But there is also a monetary benefit for emerging economies. To the extent that US dollar weakens, the fortunes of governments and companies in emerging countries improve. That's because the money they owe is typically valued in dollars, meaning they can pay that money back (and fund future growth) at a discount.
When the dollar strengthens, emerging markets tend to depreciate. Source: Penn Mutual Asset Management.
In the long term, the opportunity looks even more attractive. Valuations of emerging market securities are extremely cheap compared to those of US securities, and are likely to see further growth. And even if they don't, they would probably add some diversification benefits to our portfolio and could improve our risk-adjusted returns.
What should we look for?
Most retail investors invest in emerging markets through passive ETFs such as iShares MSCI Emerging Markets ETF (EEM), or the Vanguard FTSE Emerging Markets ETF (VWO). The problem is that these ETFs are not truly diversified, and much of their exposure is concentrated in China, Taiwan and South Korea. And while there is a case for investing in stocks in those three largest, most developed economies, they are more exposed than some of their peers to these considerable short-term risks:
1️⃣The risk of inflation.
Inflation may not fall as quickly as we expected. That could mean the US Federal Reserve will continue its aggressive rate-hiking campaign for longer. In that situation, emerging market countries that have not yet raised rates aggressively might have to play catch-up. This fact could slow its growth. And if inflation is due to rise in raw material prices, countries that rely on commodity imports will likely be affected. In this context, China, Taiwan and South Korea are likely to fare worse.
2️⃣The risk of a global recession.
It may be too early to count on such a soft landing scenario and assume that the global economy will avoid a recession. Rate hikes do not slow down the economy all at once. These changes occur over time, hitting one part of the economy after another. Large exporters, such as China, Taiwan and South Korea, will likely suffer if global demand falls.
3️⃣The specific risk in China.⛩️
In the long term, holding Chinese stocks makes sense, but there are considerable risks to consider. It has a slowing economy and a serious crisis in its real estate sectors, and rising geopolitical tensions with Taiwan and the US have seriously increased the likelihood that something will go very wrong.
Which emerging market economies are looking good right now?
We may opt for the investment in chinese stocks with the recommendation we gave a few months ago. They remain attractively priced, but their downside risks have grown since we published that article. This is why we consider keeping this allocation to a small portion. Better to look for stocks that benefit from a pick-up in growth, but have relatively little exposure to China, have strong domestic growth, are less dependent on the global economy, are more resistant to swings in commodity prices and that they have an interest rate cushion that allows them to cut them if necessary. And, since no country can currently meet all of these conditions, here we show you the three that come pretty close:
Brazil.
Brazil has low exposure to China, is a net beneficiary of rising commodity prices and has interest rates that could be lowered if the economy starts to struggle. Furthermore, its domestic growth has been supported by strong fiscal stimulus and its inflation has slowed. Oh, and Brazilian stocks are very cheap right now, both compared to other emerging markets and their own history. That said, the October elections could add some short-term volatility. Fortunately, the results are not expected to alter the country's long-term prospects. You can invest in Brazil through iShares MSCI Brazil ETF (EWZ) or through the index Bovespa (IBOV).
India.
If there is a country full of interesting opportunities for internal growth, it is 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 is not overly exposed to China and has an interest rate cushion. However, unlike Brazil, India's stock market is quite expensive, its currency is showing signs of weakness and its central bank may have to raise rates further to reduce inflation. Still, Indian stocks are among the most interesting in emerging markets. You can invest in India through iShares MSCI India ETF (INDA) or through the index Nifty50 (NIFTY).
Indonesia.️
This country has carried out ambitious economic reforms since the pandemic, and appears well placed to benefit from further easing of Covid measures, which could 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. However, inflation remains high, which may force the central bank to raise rates more aggressively. Indonesia would be negatively affected by a slowdown in China and falling commodity prices, but the domestic growth prospects make it a much more interesting bet than others. You can invest in Indonesia through iShares MSCI Indonesia ETF (EIDO) or through the index IDX Composite (COMPOSITE).
Remember that neither of these economies would be immune to a slowdown in global growth or a further tightening of monetary policies, and both are important risks. But for investors with a long-term horizon, adding an investment in emerging market stocks to our portfolios (rotating some of our stocks into emerging markets) could improve the risk and return of our portfolios. And if we use dollar-cost averaging to allocate our entry points, we might even find new bargains…