Well-diversified investors maintain exposure to a broad array of asset classes. History teaches that rotation in and out of favor is virtually impossible to predict, so a measured allocation among many sectors combined with periodic rebalancing is a prudent strategy.
Sometimes, however, conditions warrant a re-evaluation of your allocation. This may well be the case for emerging market stocks in light of fundamental challenges that are likely to impede returns to U.S. investors in these more volatile economies.
Emerging market countries are generally less developed in terms of GDP per capita, economic infrastructure, market liquidity and transparency, and legal investor protections. Over the long run, investors expect higher average returns in these economies but must be willing to accept greater risk. Diversification ensures that the exposure to these riskier investments are not disproportionate and do not produce excessive losses during downturns.
But many individual investors fail to rebalance regularly, which can lead to substantial overweight in certain sectors that have enjoyed excess returns. Emerging markets could well be over-represented in many portfolios and need to be reallocated. Furthermore, the fundamental outlook for these nations and their markets appears particularly difficult in the short run.
Unlike major developed economies, many of the emerging market countries are heavily dependent upon resource extraction for a significant percentage of their income. The United Nations classifies a nation as a "commodity-dependent developing country" if their revenue from exporting commodities is more than 60 percent of total exports. Fully two thirds of all emerging countries meet that criterion, making them especially vulnerable to the recent dramatic decline in global commodity prices. Nearly one fifth of Venezuela's entire GDP, for example, is comprised of commodity exports. Russia, Chile, Argentina, Indonesia and many other emerging market countries are highly dependent upon selling their natural resources to the rest of the world.
Thanks in part to the significant slowdown in China (the largest of the emerging market countries), demand for these commodities has fallen off substantially. Compared with a year ago, those resources are selling at steep discounts and the commodity-dependent economies are suffering as a result.
Meanwhile, the U.S. dollar has staged a strong rally versus most of the emerging market currencies, thanks to the prospect of eventual normalization of the Fed's excessively easy monetary policy. The greenback has surged by 22 percent since mid-2014, improving Uncle Sam's balance of payments deficit at the expense of many emerging countries who depend upon trade surpluses.
Perhaps the most threatening development attendant to the stronger dollar is the potential for a debt crisis among emerging countries that borrowed large sums in U.S. dollars and now must repay on much more expensive terms after exchange rates are considered. It is estimated that as much as $1 trillion in dollar-denominated bonds were sold by emerging market companies and governments before the surge in the U.S. currency's value. Global bankers like the IMF are warning of growing turmoil in these markets as debt service payments become increasingly large relative to income. Imagine locking in a monthly mortgage payment of $1,000 then being told to come up with $1,200 each month instead.
Meanwhile, manufacturing outsourcing to emerging market nations has peaked and may be receding somewhat, meaning that the bounty previously reaped from the decades-long trend of offshoring U.S. jobs is less abundant and may actually be diminishing, as cheaper oil and gas entice manufacturers to bring jobs back to America. Good for us, bad for them.
All of these headwinds suggest sub-par returns for emerging markets in the months ahead. Good time to revisit and rebalance your exposure to emerging markets.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.