Ask Russ: All About Emerging Markets

by: Russ Koesterich, CFA

I've been writing a lot lately about investing in emerging markets. In recent pieces, I've explained the case for emerging market bonds as well as why underperforming emerging markets equities are worth a second look. It's no wonder, then, that many investors are asking me for more details regarding my views of emerging market debt and equities.

So today's "Ask Russ" is dedicated to answer those queries, including some questions I received during a recent call with clients.

Q: Are you concerned about how fast the emerging debt market has grown in recent years?

A: Somewhat, but I'm perhaps a little less bothered than others because:

  1. The increase has been from a very low base.
  2. Overall, emerging markets have debt levels relative to both gross domestic product and income that are still considerably lower than those of developed markets.

Q: You obviously like emerging markets. Which emerging market countries will take the lead going into 2014?

A: In 2014, some of the smaller emerging, and even frontier, markets have the potential to do well because that is where we have seen some of the best valuations and growth. I'm a little bit more concerned about some of the larger emerging markets, particularly India.

That said, on the larger emerging market front, China is one place I still like, although it hasn't paid off this year. China is a market that has underperformed for a number of years, but because of that long-term underperformance it has some very compelling valuations. And while Chinese growth is never going to resemble what it was three years ago, China is still an economy that's capable of growing 7% to 8% over the near term and probably about 5% to 6% over the longer term. That is relatively fast growth in a slow growth world. China is accessible through funds such as the iShares MSCI China Index Fund (NYSEARCA:MCHI).

Q: You say that emerging countries are like developed countries 20 or 30 years ago -- developed countries have suffered some crises since then. Do you see any potential financial crises coming up for emerging countries? If yes, what would be the potential reasons and features of these expected crises? What's the outlier risk that concerns you about emerging markets?

A: Emerging markets have gotten a lot of things right, but they're still political and corporate governance risks to consider. So where are some of the risks? The Chinese shadow banking system is one. The reason it's a concern is just that it's an unknown -- we don't know what we don't know. And it’s not even clear the Chinese officials understand the full scope of the problem.

But while I'm concerned about it, some of the recent steps from the Chinese authorities to more aggressively deregulate the financial sector are encouraging. They loosened the bounds on which the currency can trade, and they're moving to further deregulate what banks can both charge and pay for loans and deposits. This deregulation is a good thing because if it continues -- and I expect it will -- it will hopefully shrink the size of the shadow banking sector. It will also bring more transactions into the official sector, so we'll have more clarity about how bad China's debt problem is.

And while India has a lot of promise and it’s easy to construct a great long-term bullish case about the market, there also are significant risks associated with India. Normally, I mention all the things that emerging markets have done right. They’ve lowered their deficits and they’ve brought their current account deficits into line. But India’s an exception. The country is still running a very large fiscal deficit and a relatively large current account deficit. It has massive structural inefficiencies and unlike other emerging markets, it also still has a very big inflation problem.

Source: Bloomberg.

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Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Frontier markets involve heightened risks related to the same factors and may be subject to a greater risk of loss than investments in more developed and emerging markets. Securities focusing on a single country and narrowly focused investments typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise.