Don’t Be Quick to Bail on Emerging Markets
Thursday, July 4, 2013
Charles Rotblut, CFA
AAII Journal Editor

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The Rationale for Investing in Emerging Markets
Emerging market economies have become too big to ignore.

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There are long-term benefits to investing internationally.

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The first half of this year was not kind to emerging market stocks. The MSCI Emerging Markets index lost 9.4% on a total return basis during the first six months of 2013. Not only was it more than 23 percentage points worse than the S&P 500, it was also 13 percentage points worse than the MSCI-EAFE index, which includes troubled Europe. On the surface, two words come to mind: Not good.

Some of the reasons for the poor relative performance have been well publicized. China’s economy is expanding at a slower rate. A recent liquidity crisis added to concerns about the country’s monetary policy and banking system. Lower commodity prices have hurt Brazil and President Dilma Rousseff has not enjoyed the popularity of her predecessor. The recent protests over World Cup spending, public services and political corruption are not inspiring investor confidence in the South American country either. India’s economic expansion has slowed considerably due to weakness in its manufacturing and services sectors. Delays in key reforms have also hurt foreign investor confidence.

Then there is the global economy and loose monetary policies. Europe’s economic slump has reduced growth in demand for exports. Japan’s monetary stimulus and the stronger U.S. dollar have created competition for global investment assets. Adding to the competition are reduced fears about a European meltdown.

Though there are legitimate reasons for concern about emerging market stocks—particularly the BRIC countries (Brazil, Russia, India and China) that dominate most major emerging market funds—there has always been risks to investing in these markets. Volatility for these stocks is higher because the markets and economies are newer and the potential for political instability is higher.

What emerging market stocks do provide is diversification benefits, which is why I personally continue to hold Vanguard Emerging Markets fund (VEIEX). Because emerging market countries are different from the United States, the long-term performance of their market indexes is different as well. By including exposure to emerging marktets in a broadly diversified portfolio, an investor can reduce long-term portfolio risk and his dependence on the value of the U.S. dollar. Furthermore, since nobody knows which equity markets will perform best over the next 10 years, including a mix of international stocks increases the odds of being allocated to the right country at the right time.

I don’t think emerging market stocks are for every investor. The combination of price volatility, political upheaval and currency risks can make these stocks too risky for some investors’ appetites. Emerging markets also require a long-term commitment since bailing on them when performance is bad can cause significant losses to be locked in. But, I do think emerging market stocks have a role for investors with the risk tolerance to handle the price volatility.


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The Week Ahead

Second-quarter earnings season will “officially” start on Monday when Alcoa (AA) reports. Joining the Dow component will be five other members of the S&P 500, including Wells Fargo (WFC) on Friday.

There is not much on the economic calendar. The minutes from the June Federal Open Market Committee will be published on Wednesday. Thursday will feature June import and export prices. The June Producer Price Index (PPI) and the University of Michigan’s initial July consumer confidence index will be published on Friday.

The Treasury Department will auction $32 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and ’13 billion of 30-year notes on Thursday.


AAII Sentiment Survey

Due to the Fourth of July holiday, I wrote this week’s newsletter a day early, before the most current AAII Sentiment Survey results were tabulated. The updated results can be seen on the Sentiment Survey page on AAII.com.

AAII Asset Allocation Survey

June Asset Allocation Survey results:
Stocks/Stock Funds:
    62.1%, down 3.1 points
Bonds/Bond Funds:
    17.2%, down 0.9 points
Cash:
    20.7%, up 4.0 points

Asset Allocation details:
Stocks:
    31.4%, down 1.0 points
Stock Funds:
    30.7%, down 2.2 points
Bonds:
    3.7%, down 0.2 points
Bond Funds:
    13.5%, down 0.7 points

Take the survey »


Fixed-income allocations declined to nearly a four-year low as individual investors increased their cash allocations, according to the June AAII Asset Allocation Survey.

Stock and stock fund allocations fell 3.1 percentage points to 62.1%. Even with the pullback, this was the fifth time in six months that stock and stock fund allocations were above their historical average of 60%.

Bond and bond fund allocations declined 0.9 percentage points to 17.2%. This was the smallest allocation to bonds since August 2009. Nonetheless, fixed-income allocations were above their historical average of 16% for the 48th consecutive month.

Cash allocations rose 4.0 percentage points to 20.7%, the largest since March. June was the 19th consecutive month with a cash allocation below its historical average of 24%.

Last month’s rise in yields and return of volatility to the stock market left individual investors feeling slightly more conservative with how they manage their portfolios. Though equity allocations declined and cash allocations rose, both remain well within the ranges recorded by our survey over the past several months.

This month’s special question asked AAII members what, if any, portfolio allocation changes they plan to make once the Federal Reserve does decide to end its bond buying program. Responses were mixed with 38% of respondents saying they did not intend to make any changes. Slightly fewer than 11% said they will increase their stock allocation, while 10% said they would buy bonds. An equal number of respondents (8% each) said they would increase their cash holdings or sell bonds. Some members said they thought stock prices might drop in response to a change in Fed policy and create a buying opportunity, while others said the resulting higher interest rates might make bonds more enticing.

» Take the Asset Allocation Survey