Just when is a potential long-term reward worth the short-term risk? Investors are often most focused on the short-term pain of a particular event (hard to blame them), losing sight of possible outcomes farther out into the future. That could partially explain what’s going on in the emerging markets right now, at least according to Michael Hasenstab, co-director of the International Bond Department, Franklin Templeton Fixed Income Group®. In recent weeks, fear and confusion over “tapering” (the US Federal Reserve withdrawing its “QE” asset purchasing program) and unrest in several emerging markets have caused some to conclude that the short-term risk of investing in all emerging markets isn’t worth the potential long-term rewards, and many have fled. Hasenstab cautions that it’s important to keep in mind that not all emerging markets are on equal footing. And, in some cases, short-term market volatility can be viewed as an opportunity for investors, not necessarily a complete peril. Assuming the classic contrarian stance, when others are panicking is often when Hasenstab seems the most comfortable. “We believe the fear of liquidity being pulled out of emerging markets due to the Fed eventually ending its bond-purchasing program is overstated, as we do not believe there would be a massive contraction of liquidity out of emerging markets. Instead, the situation will more likely be about less new money pouring into these markets. Emerging markets no longer rely on capital inflows like they did in previous decades. In past periods, many emerging markets were dependent upon external financing. [perfect_quotes
id=”1659″] “However, today it’s quite the reverse. Emerging markets are generally running balanced fiscal and current accounts, have a surplus of savings and low debt. They’re no longer dependent on capital inflows, and therefore aren’t as reliant upon US monetary policy as they were historically. There are ample foreign reserves in many of these countries to cushion capital outflows; however, I don’t expect these outflows will be substantial.” The Economic Impact of Political Turmoil So that’s the Fed part of the recent panic. What about the turmoil in places like Brazil, Turkey and Egypt? How should investors be thinking about the risks that political and social unrest pose in emerging markets versus the economic risks? Hasenstab says you can’t separate the two, but that doesn’t mean investors should shun all emerging markets. “If there is political unrest, such as we’ve seen in parts of the Middle East, there are likely to be economic problems. Our individual country selection is critical to our investment process in determining which countries have the most attractive fundamentals. We don’t believe in buying all emerging markets as they are not all equal, in our view. We continue to favor those countries that run a good policy mix and have stayed ahead of the curve regarding fiscal, monetary and financial policy. In my opinion, country selection will be critical for investors over the next five years.” [perfect_quotes id=”1664″] From a fixed-income viewpoint, places with more political stability, including Mexico and South Korea, are areas Hasenstab favors right now. “It’s not the case that all emerging markets are experiencing social chaos or political turmoil. There are many countries that are fundamentally sound and we seek to take advantage of those opportunities. Mexico, for example, recently had an election and we believe the reform agenda will likely be an improvement.” “The consensus trade has moved from being bullish in emerging markets to overly bearish within a month, which for us is a great opportunity. The team’s investment philosophy often leads to a contrarian view during periods of market wide, panic-driven selling. I feel more comfortable today than three months ago when our views came into consensus. We’ve used this period to add to our favorite positions while others were selling, which can set the stage for potential subsequent gains once volatility subsides and valuations begin to better reflect fundamentals. Outside China, the rest of Asia ex-Japan looks reasonably strong to us, as do select economies in Latin America and peripheral Europe.” Get more perspectives from Franklin Templeton Investments delivered to your inbox. Subscribe to the Beyond Bulls & Bears blog. [php function = 1] For timely investing tidbits, follow us on Twitter @FTI_Global and on LinkedIn. What Are the Risks? All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. When interest rates rise, bond prices fall, and the converse is true. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.