If there’s one verity about investing in emerging markets, it’s this: They can be wicked volatile. You’re likely thinking, “No duh!”

But a handy, color-coded chart put together by Guggenheim Investments and based on MSCI data paints a stark picture of just how crazy emerging markets can be. For example, the top performing emerging market in 2012 was Turkey, up 64%. The following year, it finished next to last with a 27% loss. Qatar led the pack in 2011 with an 8% gain (that was a rough year for equities), and was dead last the following year when it lost 2%. In 2009, Brazil was tops with a return of 128%, only to fall toward the bottom the following year with a 7% gain.

These represent a small sample size, and not every country goes topsy-turvy on a year-to-year basis. But the chart illustrates the big picture trend of how the performance of emerging market countries can rotate significantly from year to year, which can make investing in this space a tricky game.

But it’s a game worth considering for many investors because emerging markets are so darn alluring. One of the prevailing themes in emerging markets has been the expected rise of middle-class consumers as developing nations grow their economies and bring the good life—or at least a better life––to more of their denizens.

Three years ago, a McKinsey Global Institute report predicted annual consumption in the emerging markets should grow from $12 trillion in 2010 to $30 trillion by 2025, which it says would be “the biggest growth opportunity in the history of capitalism.”

Favorable demographics are on the side of emerging markets, particularly as population trends point to Japan and Western Europe (and maybe China) becoming giant old-age homes. And while more favorable demographics in the U.S. should keep its economy chugging along with solid, if unspectacular, growth for the foreseeable future, emerging markets are likely where the action will be.

But the action is slowing, at least for now. In January, the International Monetary Fund trimmed its growth forecast for developing nations to 4.3% this year and 4.7% next year, down from an October report that pegged those rates at 4.9% and 5.2%, respectively.

The IMF cited three main reasons: slower growth in China as it tries to transform its economy from a reliance on large, state-run capital projects to a greater focus on private enterprise and consumer consumption; a much weaker outlook for Russia; and downward revisions to potential growth in commodity exporters.

But that leads to another verity about developing nations. Namely, the sector is a polyglot universe.

“‘Emerging markets’ in general is a phrase I have difficulty with because it’s such a diverse group of countries when you put Russia and Venezuela in the same group with Malaysia and the Philippines,” says Scott Klimo, portfolio manager of the Amana Developing World Fund. “To talk about the space as being monolithic is like lumping European food into one category. It’s so diverse, and there’s so much opportunity that you need to be cognizant of the landscape and where the potential land mines are.”

In comparing three broad areas within the context of emerging markets—Eastern Europe (including Turkey), Latin America and Asia—Klimo says Latin America and Asia both win against Europe on demographics, but Asia trumps Latin America regarding governance, management and structures of the economies.

Thus, it’s no surprise that by year-end 2014 nearly half of Klimo’s fund was invested in China and Southeast Asia.

“When talking about Asia and the Asean [Association of Southeast Asian Nations] region regarding the China slowdown and even beyond that, it’s quite clear the countries most affected—whether they’re developed or developing—are the commodity producers, he says. “Within Asean, Indonesia clearly is the most affected country, but Australia is just as much if not more. And so is Canada.”

Klimo notes that if China is successful in transitioning its economy from aggressive capital formation to greater reliance on consumer spending, it could potentially be very positive for many emerging markets in the Asia region. “It’s still among the most dynamic areas in the world in terms of economic activity and demographic profile,” he says.

One of his favorite countries in that region is the Philippines, where the population of roughly 100 million people has one of the youngest age profiles in the world. “That’s a tremendous opportunity for them going forward,” Klimo says. “At the same time, it has been one of the region’s poorest-managed countries for a long time, but there’s been significant progress made under [President Benigno] Aquino. What we’ve seen out of that market and economy during the past couple of years shows what its potential is if it’s managed properly. The government debt has gone from junk-rated to investment-grade, and we’re likely to see further improvements in those debt ratings.”

Klimo is less sanguine about Thailand, which recently represented nearly 7% of the Amana Developing World Fund’s portfolio. The problem there is that the country’s economic potential has increasingly been elbowed aside by political distractions. “Thailand is a challenge, and the recent efforts to impeach the prime minister who’s no longer in office isn’t a good sign and makes me more concerned about that country,” he says.

So Much Promise, But . . .
It has almost become a mantra that emerging markets are the wave of the future. But it’s hard to ignore the here and now, and headwinds facing the sector range from slowing global economic growth and currency concerns among commodity exporters to the impact of a rising U.S. dollar and the risk of capital flight when the U.S. Federal Reserve eventually raises interest rates.

In fact, the MSCI Emerging Markets Index comprising 23 countries entered 2015 on a losing streak with losses in both of the prior two years, including a 5% decline last year. And the desultory performance extends beyond that.

Chuck Knudsen, a portfolio specialist in the equity division of T. Rowe Price, says emerging markets on the whole have significantly underperformed U.S. equities in three of the past four years because growth rates of emerging markets versus developed growth have narrowed. “Expectations are more modest this year, and we think emerging markets will deliver that growth in part because margins should stabilize or improve a little bit,” he notes.

Knudsen works on the T. Rowe Price Emerging Markets Stock Fund, where in a commentary to investors the management team posits that emerging markets trade at a significant discount on an absolute and relative basis, and now offer an attractive buying opportunity for long-term investors. That said, they note that the China slowdown and the end of the global commodities boom have caused a big dispersion in the returns of emerging-market stocks.

“Last year, the performance between the best- and worst-performing sectors were the worst since 2009,” Knudsen says. “Health care was up 19.57% and energy was down 27.43%. We think that dispersion will continue, not only among countries and sectors, but within stocks within countries.”

In Russia, for example, the fund has eschewed energy-related companies in favor of a few high-quality, consumer-driven businesses. As of year-end 2014, the fund’s largest sector allocations went to financials, information technology and consumer staples and consumer discretionary stocks. The largest country weights were China, India and Brazil.

In keeping with the dispersion theme, Knudsen notes that low energy prices are hurting oil exporters such as Russia and Venezuela, but are benefiting other countries. “In aggregate, it’s a tailwind for most emerging-market countries because in many cases they’re net importers of oil and a significant portion of their current account deficit is due to their importing of energy, so lower oil prices improves their current account deficit,” he says. “It’s also allowing several countries to pull back on their subsidies, which is having a beneficial impact on their budget deficits and allowing them to recycle some of those funds into infrastructure projects. You’re seeing that in India and Indonesia.”

One of the big clouds hanging over emerging markets is the potential of rising U.S. interest rates, a concern that rocked certain emerging-market countries during the “taper tantrum” of 2013. Knudsen says T. Rowe Price expects the upcoming Fed tightening cycle will be a benign form aimed at undoing its recent accommodative monetary policy rather than an aggressive form designed to slow the economy.

“In the past when they’ve done that [a benign environment], emerging markets have done well six months out and longer because it’s a sign the U.S. market is doing well and many of these countries are exporters,” Knudsen says.

Fixed Income
Emerging-market bonds have been popular with investors in recent years, but as with equities it’s not a one-size-fits-all deal. Slumping commodities and the rising U.S. dollar have hit some emerging-market countries’ currencies harder than others, so investors need to differentiate between better-managed and poorly managed countries when looking at fixed-income securities.

“Currencies are very cheap, and by our estimation are at decade lows. But a good amount of that cheapness is warranted given the slowdown in economic growth,” says Alexander Moseley, senior portfolio manager at the Schroder Emerging Markets Multi-Sector Bond Fund.

He notes the safest and most attractive segment of the emerging-market debt asset class is dollar-denominated debt—specifically, sovereign investment-grade dollar-denominated debt—in well-run countries where the spreads relative to U.S. investment-grade spreads are at multiyear wides. Or, in other words, where they are cheap on a multiyear basis relative to U.S. investment-grade spreads.

“The second area of emerging-market debt that’s very attractive are local-currency markets where yields compared to U.S. yields are also at multiyear-high levels,” Moseley says, adding this segment is more volatile and is better suited for investors with a higher risk tolerance.

One of the largest country holdings in the Schroder fund is Brazil, where of late Murphy’s Law seems to reign supreme in economic matters. “In Brazil, we like the local debt because although the country is slowing and has deep structural problems, yields are very high, the central bank is credible and the new finance minister is trying to correct the fiscal problems the country faces,” Moseley says.

“As a fixed-income investor, as long as the country’s policy decisions are stabilizing the outlook, then you’re handsomely compensated in the local fixed-income markets,” he adds. “Equity investors are looking at different drivers.”

Moseley also likes Indonesia, where he says both the dollar bonds and the local bonds have attractive valuations. “And following the recent presidential election, the new government for the first time in many years is putting in place a deep reform agenda, which should improve the long-term growth potential of that economy.”

Even Russia, a country in the economic doghouse, has a place in the Schroder Emerging Markets Multi-Sector Bond Fund. “Russia’s economy will slow and will face difficulties for at least the next year or two, and the ruble is likely to bear the brunt of any future shocks to hit the economy—which could be numerous,” Moseley explains. “And it’s also likely there could be some corporate debt defaults in the coming years.”

That said, Moseley says he likes Russia’s shorter-duration sovereign dollar bonds. “The financial strength of the sovereign is overwhelmingly strong, and is one of the strongest in all of the countries we look at.”

He notes that emerging-market debt as an asset class has matured significantly during the past decade. “Over the past two years, the market has differentiated between better and worse stories, meaning we haven’t seen a contagion across the entire asset class like we saw in the crisis during the late 1990s,” Moseley says. “The main emerging-market debt index had gone from three-quarters non-investment grade to three-quarters investment grade. And we’re likely to see some downgrades from countries with investment-grade status. But at the same time, we’ll likely see further upgrades from those countries that pursue strong policies.”

And so it goes with emerging markets, a protean sector that always keeps investors on their toes. Armand Atkinson, a financial planner at JHS Capital Advisors in Tampa who serves a mainly mass-affluent client base, typically includes a 10% to 15% slice of emerging markets in client portfolios via exchange-traded funds and mutual funds. He says he previously had focused on the BRIC countries (Brazil, Russia, China and India), but has since shifted to a more country-specific strategy.

That means Brazil and Russia are out, but he still likes China and India. “I think China will keep cranking for the foreseeable future, and India seems very focused on improving its infrastructure, which should have a positive long-term effect on the economy,” Atkinson says.

He also likes Mexico, in part because it’s a big trading partner of the U.S. “Investors look at emerging markets because the logic is they offer more upside potential,” Atkinson says. “But most U.S. investors already have exposure to emerging markets to some degree through their 401(k)s, 403(b)s or IRAs, so they need to be mindful not to double up on their exposure, so to speak.”
 

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