Risks increasing in Emerging Markets – investors should review exposure

Emerging markets have become a bigger part of most global portfolios. Even private investors have followed institutional funds seeking more rapid growth in developing economies. But, despite the higher risks, the stronger growth of these economies has not translated into better investment performance. Over the first half of 2013, emerging markets are down 10% on average, whilst the US Dow Jones Index is up 14%. Rarely has asset allocation between mature and emerging markets mattered quite so much. What has gone wrong?

After the banking crisis, emerging markets looked good compared to the West. Most banks in emerging markets were not overextended, and the countries themselves were running large budget surpluses. Strong pricing for oil, metals and other commodities, delivered growth and sound sovereign credit. The lower US Dollar also helped businesses based in emerging markets to access cheap finance for growth by borrowing Dollars. It seemed prudent, despite higher risk, for an increasing portion of portfolios to be allocated to these growth areas.

Although the US and Europe were struggling in 2009, China came out of the crisis strongly, boosting its growth with higher spend on infrastructure. Few were concerned at the time that this might fuel unproductive spending and create bubbles in shadow banking, commodities and property. Now, much of that boom is fading. China is moving to unwind its excesses, re-orienting its economy to lower growth and a focus on consumption. The US economy, in contrast, has rebounded more strongly than most predicted.

The boom in emerging markets sucked in hot money. Capital inflows into Asian markets have driven those currencies up to over-valued levels, incapable of competing as strongly as before. Weaker productivity growth has contributed to this problem, as has increased competitiveness from US manufacturing. The US is now benefiting from its cheap shale oil which has cut energy costs. Population ageing in China poses an additional problem for productivity growth, as younger workers are more mobile and skilled in manufacturing. Brazil and Russia have been very dependent on commodities, and face social challenges now that their revenues are weakening. Many investors overlooked political risk in emerging markets: Brazil has fallen 22% this year, and Egypt is down 14%. If national budgets are hit by commodity weakness, expect more tax on other businesses operating in these countries.

In fact, history shows relatively little correlation between stockmarket performance and economic growth. It is a mistake to think that a high growth economy means high growth shares. Chinese shares were so over-valued 5 years ago that investors have lost money, despite a decade of strong economic growth. Currency is also a factor to consider; sharp devaluations on Asian currencies such as the Indian Rupee, offset stockmarket gains for international investors. The risk / reward calculation is complicated, even without factoring in the risks from social unrest in countries like Egypt, Greece, Turkey and Brazil.

Surprisingly, the bets that have paid off this year have been in some of the Middle East and North African frontier markets such as Saudi Arabia. The benchmark for frontier markets is up 9% over six months, but even so still lags lower risk, large capitalisation, US shares. Global funds that have been under-exposed to the largest markets – instead favouring emerging markets – will have found it extremely hard to keep up with their benchmarks.

Investors need to reconsider their emerging market investments, ensuring that this more volatile higher risk area is a relatively small component of total portfolios. In the immediate aftermath of the 2008 crisis, emerging markets looked like a safe haven. Clearly many investors underestimated the risks, failing to understand the true nature of these economies and how relatively young their democracies are. Long term portfolio performance comes from structuring an asset mix to manage investor anxiety, as much as it depends on good stockpicking. Investors need to fit their emerging markets exposure into their overall risk tolerance.

A version of this article was published in the Herald on July 6th 2013

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. Data and content provided are for information, education, and non-commercial purposes only. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

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