Brighter Days Ahead for Emerging Markets?

Note: This article is part of Morningstar's December 2013 Emerging-Markets Week special report. An earlier version of this article appeared Sept. 25, 2013.

Let's take a flashback to January. If you had told a room full of investors then that between U.S. stocks and emerging-markets stocks one group would be in negative territory near year's end while the other would be up nearly 30%, a majority might well have guessed it would be U.S. equities that would be stuck in the doldrums. After all, the fiscal cliff, the budget sequester, and other issues were casting a pall over our economy at that time, while many assumed emerging markets would continue rolling along. Fast-forward to now and the reverse is true. U.S. stocks have sustained their rally while emerging markets have languished.

But even if some investors have soured on emerging-markets equities given concerns about slowing growth and poor performance so far in 2013, Morningstar experts who follow them remain guardedly optimistic about their long-term prospects, even if the near-term outlook remains cloudy.

Tapering, China in Focus
Among the biggest near-term hurdles our experts cited were slowing growth in China and an expected tapering of the Fed's bond-buying program.

Bob Johnson, Morningstar's director of economic analysis, says China's economy, in particular, has a big impact on other emerging markets. "China is a major export market for many emerging-markets countries, especially those that are commodity-based," he says. "China has been hit hard by slowing exports to developed countries as well as an intentional shift from emphasizing fixed investments to consumption. Rising debt levels aren't helping either as Chinese debt now represents more than 200% of the country's gross domestic product."

In addition, Johnson explains that the Fed's tapering decision will have an impact abroad, as well. "When U.S. interest rates were held incredibly low by the U.S. Federal Reserve, emerging markets with higher growth rates and more attractive yields saw massive capital inflows," he says. "With the Fed's threat of ending bond purchases, U.S. rates jumped sharply. Those higher rates drew more capital back to the U.S. Those outflows from emerging markets depressed currencies [in them] and ignited more inflation, slowing growth at least temporarily."

For now, Johnson remains cautious about what the future holds for emerging-markets equities. "The worst of the emerging-markets equities performance may be behind us," he says. "Though, even as valuations have become more attractive, I still believe that emerging markets are currently not worth the extra risk, at least in the short and intermediate term. That is especially true as many emerging markets remain dependent on an improving U.S. economy for their own economic growth."

Still a Good Long-Term Bet
Political unrest in places such as Thailand and infrastructure problems in India and Russia have added to the doom and gloom surrounding emerging markets. But despite the near-term worries, the Morningstar experts we spoke to said emerging-markets equities should be strong performers over the long term.

"Emerging-markets stocks in general have good--albeit volatile--prospects over the long run from here," says fund analyst William Samuel Rocco.

Morningstar equity analyst Zhao Hu agrees. "Emerging markets' long-term economic growth and risk profile have not changed despite recent volatility," he says. "The fundamentals of firms who will reap benefits from secular tailwinds, such as rising health-care spending in China and infrastructure spending in India, have not changed. Considerable pessimism in emerging-markets stocks will create good buying opportunities for quality companies."

Experts Say Be Selective
For investors looking to add emerging-markets exposure, Morningstar senior fund analyst Patricia Oey suggests seeking out companies positioned to benefit from the rise of the emerging-markets middle class "who will spend money on financial products, health care, consumer services, and consumer products."

But she cautions against blindly investing in countries that maintain tight government controls over companies. "In the larger emerging-markets countries, many of the liquid, large-cap names are government-controlled entities which may not always operate in the interests of shareholders," she says.

As for how to best invest in emerging markets now, Oey says, "We recommend investors consider countries or regions with relatively healthy long-term fundamentals, as well as a roster of diverse, investable, relatively well-run companies leveraged to domestic-growth trends, such as Southeast Asia and Mexico. South Korean companies are also an interesting option. Many large-cap South Korean companies are global exporters in the consumer electronics and auto industries and will likely benefit in the short term as the U.S., as well as Europe, continue to recover. In the long term, many of these firms will benefit from a growth in demand from the emerging markets." (Click here to read Oey's recent article about how emerging-markets fund flows tend to track the category's performance.)

"Good, diversified emerging-markets funds still have a valid place in the portfolios of long-term investors," Rocco says, "and it can pay off to add to one's emerging-markets exposure when such stocks are generally out-of-favor--as they are now--provided one understands that these stocks could well fall much further from here before they rebound."