by Paul Christopher, CFA®

Head of International Strategy, Co-head of Global Real Asset Strategy

Analysis and outlook for the global economy

• We see a balance between the risks and the rewards of investing in emerging markets.
• We recommend that investors weigh near-term risks with potential longer-term benefits of maintaining investment allocations to emerging markets.

What it may mean for investors

• Investors should set long-term targets for emerging-market equity and fixed income allocations and then gradually move exposures towards those targets.

A Balance of Risk and Reward for Emerging Markets

In the current market environment, it appears that many investors are hesitant to consider adding emerging market exposure to their holdings. Emerging markets likely will face some periodic volatility this year, but, so far, we see a balance between the short-term likely risk and rewards for investing in this collective region. Below we discuss our views on some of the risks and rewards.

Weakened commodity prices: Falling oil prices last year sparked selling in emerging markets as some investors feared that Russian and Venezuelan financial stresses might spread across emerging markets. However, we expect modest commodity price stabilization and eventual recovery in the coming years.

Global financial flows: Investors seeking yield have favored emerging markets in recent years but may rethink the decision if, as we expect, the Federal Reserve (Fed) raises interest rates and narrows the yield differential. Any market volatility related to a Fed rate hike may be short-lived, however, if U.S. yields rise only gradually and from very low levels. This measured-rate-increase scenario probably would leave emerging-market yields still higher than U.S. yields, and many of these developing countries with prospects for faster economic growth than most developed markets.

Currency matters: Developed- and emerging-market currencies weakened against the U.S. dollar at the end of last year, but two factors likely helped emerging-market currencies hold their value better. First, relatively faster emerging-market economic growth should buoy their currencies against the U.S. dollar. And second, Japanese and European policies intend to push down their respective currency values to stimulate economic growth, reverse falling inflation, and help guard against deflation.

Long-term prospects are constructive, on balance

Reforms encourage local businesses and force them to compete globally. For instance, China is a leading global exporter but now is targeting more competitive service industries. It appears new regulations are removing the floor on lending rates and the cap on deposit rates that for years have blocked competition, ensured bank profit margins, and promoted riskier and less transparent lending channels. Chinese leaders also want their country’s banks to compete internationally, and to support this objective, they are preparing to open China’s currency to international exchange.

Social and economic stresses also motivate reforms elsewhere. Governments in countries as diverse as India, Indonesia, and Thailand are bowing to pressure to improve infrastructure, reduce national budget subsidies, and improve competition. Anecdotally, our global travels consistently show us how, in recent times, low rates have lulled companies into borrowing, which tends to delay cost-cutting measures and stunt productivity and wages. In one case, Mexican labor reforms removed hurdles to hiring and firing workers which should help reduce Mexico’s informal labor market. Educational reforms in Mexico, Brazil, and other emerging economies, address the need for faster productivity growth. In addition, Mexico has changed a moribund oil production system of 75 years, opening to international expertise as productivity of its shallow-water wells declines.

These reforms are still developing, and the reformers face formidable challenges. One risk is that political forces may block modernization efforts. In Brazil, for instance, government intervention in the local economy remains a significant impediment to growth. A second risk is the potential economic disruption of reform. In particular, China is trying to close down large, inefficient state-owned businesses, but these closures may create unemployment and an increase in financial pressures on many Chinese banks.

Investment recommendations

Reform-driven increases in wage and spending growth may add several billion new consumers to the world economy and, in our view, represent some of the best long-term investment prospects for global investors. Investors in emerging markets should recognize that even though short-term problems and long-term risks exist, it is appropriate to maintain an overall positive view on emerging equity and bond markets for the long term. This perspective should help align long-term goals with potential opportunities. We recommend setting targets for emerging-market equity and fixed income allocations and then gradually move exposures towards those targets.

Risk Factors

Investments in fixed-income securities are subject to interest rate and credit risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than their original cost upon redemption or maturity. Investing in foreign securities presents certain unique risks not associated with domestic investments, such as currency fluctuation and political and economic changes. This may result in greater share price volatility. These risks are heightened in emerging markets.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII) WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A. Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy.  Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained. Any market prices are only indications of market values and are subject to change.

Brokerage products and services are offered through Wells Fargo Advisors. Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company.  First Clearing, LLC. Member SIPC, is a registered broker-dealer and Non-bank affiliate of Wells Fargo & Company.  CAR 3015-01866

INVESTMENT PRODUCTS. NOT FDIC INSURED. NO BANK GUARANTEE. MAY LOSE VALUE.

© 2015 Wells Fargo Investment Institute. All rights reserved.

*You need Adobe ® Reader ® to read PDF files. Download Adobe Reader for free.