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Emerging markets are supposed to be the engine of global economic growth, but they’re looking more like the caboose of late.
The MSCI Emerging Markets Index, down roughly 6.5% this year, is off to its worst start since 2008. Emerging-market bonds have fallen too, and countries like Argentina have seen their currencies plunge as much as 13% in just a few weeks.
The rout in these markets has helped pull the S&P 500 index (.SPX) down about 4% so far in 2014. If developing economies get much worse, U.S. companies could feel the effects.
"The more global U.S. earnings are, the more they'll be influenced by these markets," says Rudolph-Riad Younes, an international fund manager with R Squared Capital Management in New York.
Here's a Q&A to help sort out the role of emerging markets in your portfolio along with ideas on how to invest.
Q: Are the troubles in emerging markets a temporary setback or the start of a longer downturn?
A: Emerging markets have always gone through boom-bust cycles and may be entering another bust phase. Inflation is rising and currencies are weakening. And growth in the developing world has slumped to 3% from roughly 6% in 2010, according to economist David Rosenberg at investment firm Gluskin Sheff in Toronto.
Back in the U.S., the Federal Reserve is tightening the reins on the easy money that had been flowing into developing countries and lifting their asset prices. With investors pulling money out of these markets now, central banks in Turkey, South Africa and other countries are raising interest rates in a bid to defend their tumbling currencies. If higher rates are here to stay, they would put the brakes on economic growth and consumer spending, and reinforce a downward cycle.
"This is a region that thrives on confidence and liquidity," Rosenberg wrote in a recent note to clients. "Both are coming under greater scrutiny now as investors vote with their pocketbooks."
Q: What's the outlook for China?
A: China's $9.4 trillion economy — the world's second-largest after the U.S. — is expected to expand roughly 7% this year. But China's economy has been weakening since 2010, when growth hit 10.4%. And that 7% figure may now be a stretch: A recent report that Chinese manufacturing was contracting spooked investors, who were already worried that rising debt has inflated a credit bubble in China.
The bigger concern is that China's economy is entering a more mature phase of slower growth, and the country will spend less on iron ore, oil and other raw materials. Countries like Indonesia, South Africa and Brazil that export to China benefited from a "demand shock" that sent commodity prices soaring from 2002 to 2007, says Younes at R Squared Capital.
Part of that lift came after China launched a $580 billion spending program in 2008 to build roads, airports and other big projects. But spending on these "fixed asset" projects has been slowing since 2010, sending prices for raw materials lower. As these exports to China slowed, countries have seen their currencies weaken and trade deficits rise.
The slowdown may not be temporary either.
"China will be hard-pressed to sustain 7% growth," says Rusty Johnson, a money manager with Harding Loevner, an investment firm in Bridgewater, N.J. Beijing has "played the fixed-asset investment card" and now must remake its economy to focus more on consumption and services.
"That won't be great for the commodity guys," Johnson notes, since China will be importing less raw materials.
Q: What's the impact for U.S. investors?
A: Most small and mid-size U.S. companies don't sell very much in the developing world. But big U.S. multinationals get around 40% of their profits in foreign markets. And while Europe is a big piece of the profit pie, much of the growth comes from developing countries.
"It's logical that a slowdown in developing markets would impact some U.S. firms," says Younes.
Even a slight shift in sentiment can ripple through to the U.S. The S&P 500's gains over the last 18 months can be explained almost entirely by expanding P/E ratios, says Sammy Simnegar, manager of the Fidelity Emerging Markets Fund (FEMKX). That suggests the "easy money" has been made, and the "smallest whiff" of bad news in foreign markets could send investors fleeing from risky assets, including U.S. stocks.
For now, emerging markets aren't imploding. Some analysts argue they look cheap relative to developed markets. And while they're likely to be more volatile, there are still opportunities for U.S. companies to sell more goods and services in these countries. "We could end up with weaker currencies and slower growth rates," says Johnson, "but it's not the end of the world."
Q: Are there still opportunities in emerging markets?
A: Yes, but investors should be selective, Johnson says, and they should invest gradually to avoid another downdraft.
Stock market performance among developing countries is diverging, in fact.
Brazil's market tumbled 16.5% in U.S. dollars last year, while Mexico's market lost just 1.2%. Frontier markets including the Middle East and Africa surged 25.9%, according to the MSCI Frontier Markets 100 Index. And while China's Shanghai market slumped 7.7% in 2013, other Asian markets like Taiwan and Korea posted modest gains.
Overall, investors should emphasize developing-market companies with costs in local currencies and profits in U.S. dollars, Simnegar says. Weaker local currencies should boost profit margins and exports for these firms, and they should see gains from stronger U.S. sales.
Mexico, for example, is benefiting from its proximity to the U.S., Simnegar notes. The Mexican government is making economic reforms and opening up the domestic energy industry. In addition, Mexican labor rates are now competitive with Chinese rates for goods shipped to the U.S.
One way to invest: the iShares MSCI Mexico Capped ETF (EWW). The ETF tracks an index of major Mexican stocks and has returned an average 17.6% over the past five years, according to iShares.
Another option: Buy a more globally diversified fund that can avoid vulnerable regions and companies. These funds can be quite volatile, but some have beaten their benchmarks over many years and offer exposure to some of the fastest-growing companies in the world.
Some top performers, according to Morningstar, include Harding Loevner Emerging Markets Portfolio (HLEMX), Fidelity Emerging Europe, Middle East, Africa Fund (FEMEX), and Northern Multi-Manager Emerging Market Equity Fund (NMMEX). The funds have outperformed their benchmarks and ranked in the top 20% of their categories over the last five years, according to Morningstar.
Key risks: The funds are volatile and while they may outperform the indexes, they can post steep losses.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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