Emerging markets produced great returns last year, but there were also several reminders of how risky they can be. In May and June, fears of interest rate hikes in some of the most developed nations sparked a broad-based selloff in emerging-market debt and equity. Then a military coup in Thailand sent the local stock market down 15% in December as capital controls were implemented. And the president-elect of Ecuador roiled the local debt market when he reiterated plans to "restructure" the nation's debt. More recently, Venezuelan President Hugo Chavez announced plans to nationalize the nation's largest telephone company. Curtis Mewbourne, head of the emerging-markets portfolio team at the bond fund giant Pimco, makes a distinction between what he terms emerging-market "contagion" and the political and financial risks of investing in individual emerging markets. In commentary posted on the company's Web site earlier this month, the fund manager compared days when all emerging-market asset classes are trading down in response to an external event to a local grocery store handing out a sign reading "10% off all items." "On such days, you don't need to buy everything, but it's certainly a good time to stock up on things that you want to have in the coming weeks and months," he says. But in the case of Ecuador, Pimco's fund managers unloaded their exposure to the country even before the election, avoiding the eventual selloff in government debt, because they were concerned about the quality of the various presidential candidates and their platforms. In retrospect, Mewbourne says, this was a prudent decision "not because we 'predicted' the unpredictable ... but because we believe that proper investment decisions always involve weighing the potential risks and returns within a risk-management philosophy that stresses capital preservation."
Mewbourne expects that the asset class will continue to benefit from improvements in the economic fundamentals of individual emerging markets, along with supportive global economic conditions. These have dramatically reduced risk even as returns have remained robust. He says some of the best potential returns can be found in local emerging markets, where interest rates remain substantially higher than in their developed-country counterparts. "Strong macroeconomic fundamentals and deep-seated institutional changes in the conduct of fiscal and monetary policy have set the stage for a secular convergence of emerging-market local interest rates toward developed-country levels," he says. As for contagion, Pimco fully expects there will be additional bouts of volatility but expects they will more likely be transient than permanent. On the political front, the fund family will be paying close attention to developments in those countries that just completed presidential elections, such as Brazil, Colombia, Mexico and Peru, where the focus will shift to policy implementation. On the financial side, Mewbourne says risks remain for those countries with large current account deficits such as Hungary, Turkey and South Africa.