Are emerging markets worth the risk?

Currently, emerging market valuations are cheap. But investors may want to hold off on adding exposure.

Listen to the full podcast on AdvisorToGo.

That’s because emerging markets reached their cyclical peak in 2011, and are now facing more headwinds than tailwinds, says Michael Peterson, managing principal and portfolio manager for International, European and Global Value Strategies at Pzena Investment Management in New York. He manages the Renaissance Global Value Fund.

In China, for example, capital spending between 2000 and 2011 was unsustainable. “[That] was, in part, responsible for the worldwide boom of commodities, including energy, which was also not sustainable.”

Read: When value beats growth

So, “you’ve seen the wind coming out of the sails of that boom,” says Peterson. “And there has been a huge amount of valuation destruction in areas related to Chinese capital spending, and to commodities and energy generally.”

Read:

• Goldman Sachs slashes oil outlook
• How $40 oil will impact the U.S. economy

That has occurred for the following two reasons.

• Companies related to the China boom, and to the commodities and energy boom, built high amounts of invested capital prior to 2011, says Peterson. “In other words, [they] expanded their balance sheets many-fold during the peak. As a result, there’s going to be a period of excess capacity and poor earnings across large parts of the emerging markets.”
• A smaller headwind, he notes, is the fact that “a number of companies in the emerging markets [space] are facing balance-of-payments crises where they’re running current account deficits.” These companies face risks in terms of U.S. rate rises, in particular, and the implications that those hikes would have for their fiscal positions.

Read: Markets skittish over Fed rate decision Thursday

As a result, says Peterson, “It’s difficult to dramatically increase exposure to [emerging markets]. They have really come off a peak, as opposed to getting to levels at which we think you’re being adequately compensated for the risks you run. We have some exposure, but we’re not all in on that part of the portfolio.”

He cautions that while a number of emerging market companies appear cheap, “they tend to be a little less cheap when you think of them on a long-term, normal-earnings basis.”

Read:

High correlation between Canada, emerging markets

Finding opportunity in volatility

Investors flock to Japan, emerging markets

4 ways cheap oil helps emerging markets