Prospects in 2023 for emerging market stocks to do as well as they did in 2022 may be dimming. Financial planning firm Facet recently advised clients that it is reducing their allocation of emerging market equities to 5% from 10%. The move, which reflects several key developments, aims to achieve a better balance between risk and reward. The firm also explained where it is putting that money instead and why.
Consider working with a financial advisor as you work to ensure that your asset allocation aligns with your risk profile, goals and timeline.
That Was Then, This Is Now
Emerging markets outperformed many other sectors last year. While the Standard & Poor’s 500 index of U.S. stocks tumbled nearly 20%, Brazil’s benchmark 84-stock Bovespa Index, best known as Ibovespa, turned in the best performance in the world with a return of 4.97%. India was close behind, where the benchmark BSE Sensex index showed a gain of 4.4%, and the Straits Times Index in Singapore’s closed out the year with a gain of 3.9%.
But don’t wait around for an encore. The firm cites three reasons for reducing exposure to stocks of companies located in countries such as China, India, Brazil or Taiwan.
Why 2023 May Differ
Facet cites slowing growth, comparatively strong U.S. economic growth and political risks as factors that raise the risks of emerging market equities.
Slowing Growth, or Worse
The Federal Reserve’s battle with inflation is designed to slow growth and consumer spending. As of January 2023, the battle was heating up: the personal consumption expenditure rose 5.4% year-over-year, up from December’s gain of 5.3%. The increase raised Wall Street’s expectation that the U.S. central bank will continue raising the cost of money by hiking the federal funds rate.
Such a scenario augurs poorly for emerging markets, which historically have struggled during times of slowing growth. “This includes times when the U.S. did not fall all the way into recession, such as 2018, 2015 and 2011,” the firm said. “Slowing growth is likely in 2023.”
U.S. Growth Could Weigh on Emerging Markets
On the other hand, if U.S. markets do well compared to emerging markets then interest rates could remain high. “Higher interest rates tend to cause the U.S. dollar to be strong, and this tends to be a drag on non-U.S. investments,” Facet said.
Political Risks
The third factor is the increased political risk entailed in investing overseas. That’s because of the possibility third-world “governments do something problematic for the local economy and/or investors,” Facet wrote to clients. “Recent events in Russia, China and Brazil have highlighted this risk.”
Although the firm did not go into detail, a number of analysts point to the Russian invasion of Ukraine that has already hit energy, grain, food and commodity prices. China continues to see economic weakness and more potential fallout from the pandemic. And the potential in Brazil for conservative protests, disruption and even violence against the leftist government of Luiz Inácio Lula da Silva shouldn’t be ignored. The inflation risk has grown with Lula’s $31.6 billion infrastructure spending proposal.
Other Emerging Market Risks
Overall, emerging market growth is expected to slow a bit from 2022, to 2.9%, according to a J.P. Morgan forecast. Besides the above-mentioned economies, some analysts are keeping a wary eye on political events in Nigeria, Turkey and Argentina, where elections are scheduled this year that may strengthen the economic mismanagement of the incumbents, or see them ousted with newcomers who could face an uphill battle implementing needed reforms.
Another factor: One of the key influences on emerging markets in 2023 will continue to be the global and U.S. economic cycles and how dependent individual countries are on investment and trade with those markets.
Alternatives to Emerging Markets
Facet says it currently favors domestic alternatives for the money pulled out of emerging markets.
“This money has been reinvested in larger U.S. companies, split evenly between the Value ETF and the iShares U.S. Quality Factor ETF,” the firm told clients. The latter exchange-traded fund invests in large- and mid-sized corporations. Facet is also doing some tax-loss harvest transactions for clients with tax-paying accounts.
The Bottom Line
No matter what the U.S. economy does in 2023, Facet says it makes sense to decrease client holdings in emerging market equities, either stocks or funds. A combination of rising interest rates, a growing U.S. economy and political risks combined with comparatively strong domestic alternatives, makes a reduction in emerging markets compelling. Consider mid-cap and large-cap domestic equities as potentially strong substitutes for what worked so well in 2022.
Tips on Investing
- The combination of changing market circumstances and your evolving risk profile and timeline can make asset allocation decisions challenging. A financial advisor can be immensely helpful. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Check out SmartAsset’s free asset allocation calculator to see what mix of securities may help you meet your goals.
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