Emerging Markets: Are They Ripe for an Upswing?
investing-my-money | Read Time: 3 minutes
By David Navarro, CFA® | Published: April 2021
With the majority of market chatter engulfed in the inflation debate, certain asset classes have been a focus for portfolios. Typically, investors flock to commodities during times of high or expected high inflation. Another asset class that can help mitigate inflation risks in a portfolio is emerging market equities. Emerging markets historically provide a buffer to high inflation and a decrease in the value of the U.S. dollar. However, the emerging markets arena has changed by geography and sector over time and investors should understand those changes before blindly investing in the space.
When a fear of higher inflation is present, or concerns surrounding government deficits devalues the currency held, investors typically seek investments that have a “store of value” quality to them. Hard assets, such as commodities, real estate, and even art, are the traditional venue for that viewpoint and prices in commodities usually surge higher.
Emerging markets also perform well during these periods. Why do emerging markets do well when the U.S. dollar drops?
One obvious reason is a dollar decrease makes most everything priced in foreign currencies move higher, including emerging market stocks. Another factor is how these countries finance their economies. Most of them borrow in U.S. dollar terms. If the U.S. dollar decreases, that will decrease their financing costs resulting in a stronger financial position. Lastly, when the U.S. dollar drops and the emerging market currencies increase, the costs of imports into these countries decreases. Decreasing import costs can strengthen the trade surplus of a country, again resulting in a stronger financial position for these countries.
The inflation charts display how certain asset classes perform during different inflationary environments (combinations of high/low inflation and rising/falling inflation). As you can see, emerging markets perform extremely well in three out of the four periods. In fact, emerging markets outpace commodities in all four periods.
Even though the probability of a low or falling inflation environment is unlikely, there are many experts that fall on either side of the inflation argument. Thus, there is no guarantee what path inflation may take. With that in mind, generally during a low and falling inflationary environment, commodities produce negative returns. In this scenario, commodities would be a drag on a total portfolio. Even though they typically do not generate the greatest returns during period of low or falling inflation, emerging markets can still produce a small positive return, leading an investor to prefer this asset class ahead of commodities.
One caveat exists when utilizing historical figures to examine emerging market returns. Aside from the typical “past returns do not guarantee future performance,” a more specific caveat to emerging markets is how they have developed over the past 30-40 years.
Historically, emerging markets has consisted of commodity-driven economies split between Latin America and Asia. With the growth of China over the past 20 years into a global superpower, the emerging market index has shifted towards Chinese dominance and included some prominent technological, consumer discretionary companies. Companies such as Alibaba, Tencent, and Taiwan Semiconductor hold top positions inside emerging markets portfolios.
In the end, a portfolio managers due diligence is paramount when selecting an emerging markets investment to know what type of exposure you are getting by region and sector.
About the Author – David Navarro, CFA®
David Navarro, CFA® is the Director of Research at West Capital Management, a subsidiary of WSFS Financial Corporation. West Capital Management focuses on developing custom planning and investment strategies tailored to each client’s unique circumstances and greater ambitions. David graduated with a B.S. in Finance from Rutgers University. He can be reached via email at firstname.lastname@example.org.
This communication is provided by West Capital Management (“WCM” or the “Firm”) for informational purposes only. Investing involves the risk of loss and investors should be prepared to bear potential losses. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. No portion of this commentary is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Certain information contained in this report is derived from sources that WCM believes to be reliable; however, the Firm does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investment products, which otherwise have the effect of reducing the performance of an actual investment portfolio.
WCM is the business name of WSFS Capital Management, LLC. It is an SEC registered investment adviser that maintains a principal place of business in the Commonwealth of Pennsylvania. The Firm may only transact business in those states in which it is notice filed or qualifies for a corresponding exemption from registration requirements. For information about WCM’s registration status and business operations, please consult the Firm’s Form ADV disclosure documents, the most recent versions of which are available on the SEC’s Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov. WSFS Capital Management, LLC, is a wholly owned subsidiary of WSFS Financial Corporation.
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