Slowdown in the Chinese economy, wild swings in currencies and tumbling commodity prices are dragging emerging markets down. Brazil and Russia have already entered recession. Most of the investors fear that the financial crisis in emerging economies is a bigger issue than Eurozone concerns and a hike in interest rates in the U.S. Emerging markets witnessed capital outflows faster than ever in the fourth quarter of 2015. They are now facing a wide range of risks that might weigh on their sovereign, corporate and bank ratings.
However, in the face of insurmountable odds, emerging countries have remained relatively resilient for the last couple of years. What protected them from a full-blown crisis was perhaps their beefed up foreign exchange reserves. Macroeconomic headwinds notwithstanding, emerging countries are also projected to grow at a steady rate in the near term.
Moreover, fears that have resulted in selling, deleveraging and down-sizing emerging economies also now work in their favor. Bargain-hunting investors should look for investing in this oversold market. Hence, if an investor is willing to stay invested for the long term, then emerging market funds can be a good bet.
Investors Pull Money from Emerging Markets
Investors pulled $270 billion from emerging markets last quarter that surpassed withdrawals during the financial crisis of 2008. China led the outflows, with about $159 billion pulled out of its economy in December alone. Barring China's outflows, the emerging markets could have witnessed inflows in the quarter, according to Capital Economics Ltd.'s economist William Jackson.
Concerns about weakness in China's currency led investors to dump riskier assets. Last year, China surprised investors by devaluing its currency, which eventually led to a rout of $5 trillion in the nation's equity markets. Subsequently, China plunged into bear market territory last month, with its manufacturing activity contracting at the fastest pace in January since August 2012.
Separately, according to the Institute of International Finance, investors pulled $735 billion from emerging economies in 2015, the first year of net outflows since 1988.
Emerging Markets Risk Intensifies
Higher interest rates in the U.S., a stronger dollar, declining commodity prices and a rise in geopolitical tension are adversely affecting credit ratings in emerging countries. Fitch Ratings downgraded Brazil's and South Africa's sovereign ratings in December. These macroeconomic headwinds are also negatively impacting emerging markets' corporate and bank outlook.
Meanwhile, private sector debt turned out to be a key challenge in emerging markets. Private sector debt has surged in emerging markets in the last 10 years. Seven large emerging nations including Brazil, India, Indonesia, Mexico, Russia, South Africa and Turkey witnessed a collective rise in their private sector debt to an estimated 77% of their GDP in 2014, significantly up from 46% in 2005, according to Fitch's analysis.
Is It All Over for Emerging Markets?
On an individual basis, however, most of these emerging economies haven't added much debt compared to the size of their economies. India's and South Africa's private debt-to-GDP ratio increased by 17 and 11 percentage points, respectively, according to Capital Economic Ltd. The private debt-to-GDP ratio for Malaysia and Indonesia also came in at 18.5 and 12.5 percentage points, respectively.
Meanwhile, growth in emerging market economies slowed down to a pace of 3.7% in 2015, according to the World Bank. A year earlier, the pace was around 4.5%. However, the World Bank expects growth in emerging economies to rise by 4.2% this year followed by a steady increase of 4.8% and 4.9% in 2017 and 2018, respectively.
Moreover, Russia's GDP, which constitutes a major part of emerging market GDPs, is also positioned to contract less, eventually having a positive impact on the overall growth of the developing nations. Russia's GDP of around $1.2 trillion is about 4% of emerging markets' $28 trillion economy.
According to Alberto Ades, head of global economic research at Bank of America Corporation (NYSE:BAC), the pace of contraction in Russia's GDP this year will slow down to 0.5% from last year's contraction of 3.7%. In 2015, Russia was responsible for reducing about 15 basis points from overall emerging markets' economic growth. This year, it is expected to shave only 2 basis points.
Separately, Daniel Hewitt, a senior emerging-markets economist at Barclays PLC (NYSE:BCS) said that emerging economies will expand at an average rate of 4.3% in 2016, higher than 4.1% last year. He believes easing of economic contractions in Russia along with Brazil and Venezuela will help emerging markets to grow in 2016.
5 Emerging Market Funds to Buy
Emerging markets have shown remarkable resilience, banking on adequate foreign exchange reserves. For example, India accumulated reserves of $325 billion by 2014, while its reserves were merely $5.6 billion in 1990, according to the World Bank data. Indonesia and Thailand too piled up $112 billion and $157 billion, respectively, by the end of 2014.
As many developing countries are in a much sounder shape than they appear, investors might have a look at emerging market mutual funds, keeping in mind a long-term view. These funds generally tend to do well over the long haul due to their higher risk content.
However, they may stand out in the short term as well. Emerging market funds had tanked almost 50% during the global financial crisis in 2008, but quickly recovered, gaining more than 65% in 2009. Also, it will be prudent to invest in such emerging mutual funds that have less exposure to the beleaguered Chinese economy.
We have shortlisted the top five emerging market funds. They have an impressive five-year annualized return, a minimum initial investment within $5000, low expense ratio and a Zacks Mutual Fund Rank #1 (Strong Buy) or #2 (Buy).
T. Rowe Price Emerging Markets Bond Fund (MUTF:PREMX) provides current income and capital appreciation. PREMX invests a large portion of its assets in government and corporate debt securities of emerging nations.
PREMX's 5-year annualized return is 3.5%. PREMX carries a Zacks Mutual Fund Rank #1 and the annual expense ratio of 0.93% is lower than the category average of 1.16%. As of the last filing, Argentine Republic 7% was the top holding for PREMX.
Fidelity New Markets Income Fund (MUTF:FNMIX) invests the majority of its assets in debt securities of issuers in emerging markets and other investments that are tied economically to these markets.
FNMIX's 5-year annualized return is 4.7%. FNMIX carries a Zacks Mutual Fund Rank #1 and the annual expense ratio of 0.84% is lower than the category average of 1.16%. As of the last filing, US Treasury Bond 3% was the top holding for FNMIX.
JPMorgan Emerging Markets Debt Fund (MUTF:JEMRX) seeks high total return and normally invests a large portion of its assets in emerging market debt investments.
JEMRX's 5-year annualized return is 4.4%. JEMRX carries a Zacks Mutual Fund Rank #2 and the annual expense ratio of 0.77% is lower than the category average of 1.16%. As of the last filing, Argentina Rep 8.28% was the top holding for JEMRX.
Fidelity Advisor Emerging Markets Income Fund (MUTF:FMKIX) seeks capital appreciation. FMKIX invests a major portion of its assets in securities of issuers in emerging markets and other investments that are linked economically to these markets.
FMKIX's 5-year annualized return is 4.6%. FMKIX carries a Zacks Mutual Fund Rank #2 and the annual expense ratio of 0.88% is lower than the category average of 1.16%. As of the last filing, US Treasury Bond 3% was the top holding for FMKIX.
Franklin Emerging Market Debt Opportunities Fund (MUTF:FEMDX) seeks high total return. FEMDX invests the majority of its assets in debt securities of "emerging market countries" that the World Bank considers to be on the developing curve.
FEMDX's 5-year annualized return is 2.3%. FEMDX carries a Zacks Mutual Fund Rank #2 and the annual expense ratio of 1% is lower than the category average of 1.16%. As of the last filing, United Mexican States 4% was the top holding for FEMDX.