Emerging markets - Tempting, but is there too much risk?

The “emerging markets” sector is an asset class within global equity markets which gets attention at different times in the market cycle. Huge gains have been made, but disasters occur fairly frequently also. These corrections wipe out massive amounts of capital as investors retreat with their money back to home base.

What about now? Is the cycle favourable to emerging market investing?

Many investors look at US stock market valuations, which are stretched as measured by the Price-Earnings ratio, and wonder if there aren’t greener pastures elsewhere, given the spectacular gains achieved by stocks trading on US markets. One possibility that often comes up during this search is called “emerging markets”.

Emerging markets are bundled together as an asset class by institutional investors. Often pension plans and others will have a percentage limit, both minimum and maximum, that they wish to allocate to that category. But there are many different types of investing opportunities and risks in emerging markets. For example, Russian and Brazil are heavily exposed to commodities while China and India have limited natural resources and huge populations and therefore must import basic materials to meet their needs.

The moniker called “BRIC” was coined a couple of decades ago referring to Brazil, Russia, India and China. More recently the term “fragile five” has been used to indicate Turkey, Brazil, South Africa, India and Indonesia. These countries are considered fragile because of vulnerabilities related to currency fluctuations, trade deficits and excessive borrowing.

Many mutual funds and ETFs have sprung up to take advantage of the sporadic investor fascination with investing in higher growth and higher risk economies in this asset class. Since the Global Financial Crisis in 2008-09, according to BCA Research, retail investors’ funds have been flowing to emerging markets at a higher than normal rate. In fact, since 2009, retail investors en masse have plunged between $50 billion and $300 billion per year into emerging markets, while simultaneously reducing their holdings in domestic-oriented funds. This is a warning sign because retail investors buying mutual funds are prone to “fad following” as a rule.

And this touches on the most important factor in emerging market cycles, the flow of money. Since foreigners’ ‘hot’ money flows in and out of various markets at different times, and domestic monetary authorities expand and contract their domestic money supply which influences stock and bond prices, it is extremely important to keep an eye on where the money flow is going. And that signals a “yellow” light of caution for many emerging markets.

According to BCA Research, money flow and credit conditions started to contract in 2013, especially in Turkey, Russia, Philippines and Malaysia. This means that the general economy and profits for specific companies will struggle to grow.

Given that the emerging markets as an asset class are so broad, there will always be a niche somewhere that makes a good investment at any given moment. But overall the trends in growth and money conditions suggest that we should be cautious, for now.