Unless you specifically manage an emerging-markets portfolio, there is a good chance you will be lukewarm on increased allocations to the world's emerging economies.
Even against the backdrop of a very solid first half of the year, most analysts and market watchers are having a hard time fully committing to a hearty push into developing countries.
“At this point, we still feel like it's a little early to do too much with emerging markets,” said Jim Russell, principal and portfolio manager at Bahl & Gaynor.
“I do think the appeal when it comes to the emerging markets is that folks are looking at something that hasn't worked for a long time,” he added. “It looks cheap, it's overlooked, and the sentiment is generally negative. So, everything is lining up for this to eventually be a pretty big trade.”
The rationales for such hedged statements are multifold, but are largely based on a surging U.S. dollar and slumping commodity prices that have contributed to vivid memories of three consecutive years of negative returns across the broad category.
The diversified emerging-markets funds category, as tracked by Morningstar, has already gained 12.2% this year through Aug. 5, but that isn't always enough to make up for the long gap between the 2012 full-year gain of 18.2%.
By comparison, the S&P 500 Index is up 8% this year, but hasn't had a negative year since 2008, when the benchmark lost 37%.
The best-performing category among emerging-markets funds, Latin America, is up 35.4% this year. But again, you have to go back to the 9.1% gain in 2012 to find a positive full year.
The worst-performing emerging-markets category, China-region funds, is up just 1.9% this year, but it did eke out a 1.5% gain in 2014.
THE CASE AGAINST
Even with the improving performance, it is often easier to make a case against investing in the emerging markets than it is to get fully behind it.
“It has not been the place to be over the past four or five years, because all the drivers have been working against the emerging markets,” said David Semple, head of emerging markets equity at Van Eck Global.
“We have seen a strong dollar, weak commodity prices and a general failure to deliver earnings growth in the emerging economies,” he added. “Emerging-market companies have been struggling with lower margins, and lower returns on equity.”
Meanwhile, running parallel to what the emerging markets have been dealing with, Mr. Semple explained that many of the developed economies have been hitching rides on record-level quantitative-easing programs designed to stimulate economic growth. And those benefits have not trickled down to the emerging economies.
But even though the emerging economies are not in positions to pump up their markets through government-backed quantitative-easing programs, they are starting to settle into a more comfortable groove.
As net exporters, most emerging economies benefit from higher commodity prices, which have yet to turn the corner in a significant way. But there has been some stabilization in the surging strength of the dollar, which also bodes well for emerging economies. And then there is the perpetual case for investing in the emerging markets in the form of the promise of an expanding middle class and increased consumer spending.
As with allocations to international stocks in general, U.S. investors tend to be under-allocated to the emerging markets. But a shift is starting.
According to Morningstar, emerging-markets funds have experienced $345 million in net inflows this year through June.
The net flows are mostly supported by more than $1 billion into diversified emerging-markets funds, which is by far the largest category at more than $271 billion.
The Pacific/Asia ex-Japan category saw net outflows of $435 million, and China region funds had $289 million in net outflows.
The net inflows this year for emerging-markets funds compare with $3.4 billion worth of net outflows for 2015.
“People who have been underweight the emerging markets for a number of years are becoming more concerned about being underweight,” said Mr. Semple. “You've certainly got to be looking at it and talking about it, and it certainly raises the question of whether allocations to the emerging markets should be increasing.”
Considering historic-low yields coming from domestic fixed-income, and the U.S. stock market hovering near record highs, Mr. Semple said investors are starting to see the logic of allocating to such an underloved category.
“Almost by default, there should be a huge attraction to emerging markets, because where else do you put your money?” he added. “Do you want to put your money in negative-yielding sovereign bonds, or an over-valued U.S. stock market?”
That is in line with the outlook from Ed Kerschner chief investment strategist and vice chairman at Emerging Global Advisors.
Mr. Kerschner advises to think not of the specific countries, but of the forces fueling the various economies.
“It's not a country story; it's a consumer story,” he said. “We think emerging markets will continue to outperform developed markets, and emerging-market consumers will continue to out-perform the emerging markets.”
The emerging-market consumer is logically seen as the ultimate byproduct of an expanding middle class. Mr. Kerschner believes you can't fully tap into that new and growing consumer spending potential by just adding broad emerging-market exposure.
“The emerging markets represent three billion new consumers, but most emerging-market indexes will give you 15% exposure to consumer stocks,” he said. “If you're buying a benchmark index or using an active manager who hugs the benchmark, you're not getting access to the consumers.”
China and India, which, combined, represent 2.7 billion people, illustrate the consumer-spending potential of those markets.
With a median population age of 27, and a population growth rate of 1.4% over the past 10 years, India represents the “best demographics in the world,” Mr. Kerschner said.
And China, which recently abandoned the one-child-per-family policy, is moving toward a consumer economy, he added.
The U.S. economy is made up of 69% consumer spending, which compares with a 61% average for all developed markets. But the consumer accounts for an average of 50% of the emerging markets, and just 37% of China's economy.
“As an economy develops, it becomes more of a consumption economy, and China is putting in policies to become more of a consumer economy,” Mr. Kerschner said.
The emerging markets are rarely considered without factoring in consumer spending. But that doesn't mean there is only one way to tap into that spending potential.
(Related read: A tale of two Chinas: one old, one new)
Jonathan Brodsky, founder and principal at Cedar Street Asset Management, says the best way to access consumer spending in emerging economies is through small-and mid-sized local companies.
“When you look at the large-cap emerging-markets space, a lot of the companies are multinationals with exposure to Europe and the United States, or large state-run enterprises,” he said. “So a lot of our holdings will be in the mid- and small-cap range.”
Jason Thomas, chief executive and chief investment officer at Savos Investments, a division of AssetMark, said a safer and simpler way to tap into the emerging-market consumer is through brand-name multinational companies like McDonald's, Coca-Cola, and even Facebook.
“You have to decide how you want to invest in the emerging markets,” he said. “But the consumer market is the easiest to access.”
Nevertheless, investing in the emerging markets entails caution.
As Luca Paolini, chief strategist at Pictet Asset Management, put it, “thinking long-term is best when it comes to investing in the emerging markets.”
“At the start of the year almost everybody had given up on the emerging markets, and now we're seeing a complete reversal of that,” he said. “From a practical point of view, this rally may pause, and maybe investors are becoming too optimistic. At this point, we're positive on emerging markets for the long term, but in the short term we're more critical.”