What's Behind the Emerging-Markets Rally?

Patricia Oey: Hi, I'm Patty Oey for Morningstar.com, and I'm here with Jeremy Schwartz. He is a director of research at WisdomTree. Jeremy, thanks for being here.

Jeremy Schwartz: Thanks for having me, Patty.

Oey: So I wanted to ask you about emerging-market funds. They've been rallying this year after a very, very long slump. Has something changed fundamentally there? And can you talk about some of the drivers?

Schwartz: I think there's two or three main things going on with the emerging markets this year. One of the big parts of the sell-off [over] the last few years was a strengthening dollar. And so the expectation [was] that the Fed was going to hike interest rates this year. At the beginning of the year, people thought maybe as many as four times, according to the Fed dot plot. Now we haven't even hiked; we're in September. People would think we might hike once in December. So that has led a EM currency rebound. So that's been very positive for support.

At the same time, you had China. One year ago, people were very worried China's going to sharply devalue the currency. Largely also on a strong dollar--that is, the strengthening dollar hurting China too much. Now, they've been weakening the currency versus a basket of currencies so that it doesn't strengthen versus the dollar too much. But people have become less nervous about what is China's influence on the rest of the emerging markets.

And then you also have this management of a lot of emerging markets are commodity-oriented and China's transition from an infrastructure investment-led economy toward a consumer economy has had an impact on all the commodities, Brazil, Russia. And so I think that has been... Do people become less concerned about China? So that's become a very positive, in some ways, relief for the rest of the emerging markets.

Oey: But fundamentally, are things better? And because emerging markets have underperformed for such a long time, it's possible that investors are possibly underweight emerging markets. Should they be, maybe stepping up their allocations at this point?

Schwartz: The U.S. investors and really global investors in any country, tend to be home country-biased. So, if you will get a global market portfolio, it would tend to be approximately 50% U.S., 40% developed international, roughly 10% emerging markets. There's very few people who probably even have that much emerging markets. I personally have this preference for emerging markets, longer and I think... You think U.S., Europe, Japan, or slow-growth emerging markets is where you have younger populations. India is a prime example of the youngest population. Real long-term ahead of it of catching up with the rest of the world on an income basis. And so, they do have the growth ahead of them, and so I would tend to be over weighting emerging markets, but my guess is most people are not even at market-weight emerging markets given the home-country bias.

Oey: Right. OK, but let's talk a little bit about the risks. So in the past, people have often talked about poor corporate governance, economic crises, political risk, and even more recently, the taper tantrum. And now we're seeing maybe the Fed's going to raise rates. Are these risks more understood now? Or are they less of a risk now? Can you talk about that?

Schwartz: What's interesting is political risk is not unique to emerging markets.

Oey: That's true.

Schwartz: We see political risk in the U.S. this year. There's a lot of uncertainty who's going to be the candidate. There's some controversial elections in the U.S. Europe has had a lot of political uncertainty between different parties. The anti-EU parties are happening. Of course, EM has specific risks, Russia is an example, right? The sanctions on Russia were very harmful for the currency. Although now, the Russia stock markets are at high, the currency's still say 50% lower than where it was. And some of it's that political risk.

So I don't think that you can avoid that anywhere. It's really what's priced into the market. Are you buying it at a reasonable price? And so I think a lot of the emerging markets do sell a discount and they probably should sell at a discount because they are riskier than the developed world. But if you're an investor, you want to take risk that you're compensated to take. And so they're cheaper. So it is actually something that I think is worth having as part of the portfolio.

Oey: OK. Well, thank you. Thank you for joining us today.

Schwartz: Thanks, Patty.