Charles Schwab: Emerging Markets Down and Out for Now

July 20, 2018 — 11:22 AM EDT

Emerging market investments have been down for some time, and if the dollar continues to move up at the pace seen in April, May and June, investors in this asset class should brace for more pain to come. After all, with lots of emerging market companies owing debt in U.S. dollars, if the dollar continues to rise, paying it back will be more costly and will put more downward pressure on the stocks in that group.

"We think having some exposure to emerging markets is still appropriate, but we are not overweight," said Jeffrey Kleintop, chief global investment strategist at Charles Schwab, in an interview. "If the dollar continues to move up, emerging markets will likely suffer sharply." According to Kleintop, the rising dollar has been weighing on emerging market investments this year and is the big factor in driving the 17% peak-to-trough decline. How the stocks in that group fair in the second half of 2018 will be dependent on movements in the dollar, noted the strategist at The Charles Schwab Corporation (SCHW).

[TradeStation is a powerful tool to take your trades to the next level. Read Investopedia's TradeStation review to explore your options.]

Emerging Market Stocks Surged in 2017

Rewind to last year, and emerging market stocks were the darlings of Wall Street, with the group up 37% in 2017. The asset class was off to a strong start in the beginning of 2018 as well but pulled back more recently. Emerging market stocks began to underperform in the middle of April and have been continuing the malaise.

Investors are worried that global economic issues will sink emerging market stocks similar to what happened in years past. Kleintop pointed to the 1995 Mexican peso crisis, the 1997 Asian Contagion and 2013 Taper Tantrum in which the Federal Reserve was taking actions to tighten monetary policy. The moves boosted the value of the dollar, which sent emerging market stocks sinking. With the Federal Reserve currently raising interest rates and central banks around the globe tightening monetary policy, those old fears are cropping back up.

"There are three drivers of emerging market stocks: currency, commodity prices and global economic growth," said Kleintop. "If global economic growth remains strong throughout the year, commodity prices stabilize and the dollar does not move too much, that favors emerging markets." However, if a full-blown trade war with China ensues and it hurts global economic growth, results in a pullback of commodity prices and the dollar rises, it will be a "toxic combination" for emerging market stocks, he said.

The Schwab strategist is in the camp that there will be a resolution with China on trade during the second half of this year and that there won't be an escalation of trade tensions, thus expecting some relief for emerging market stocks. That may not turn out in Kleintop's favor if President Donald Trump does what he says he's willing to do. In the latest salvo in the tariff battle, Trump told CNBC in an interview that he is willing to place tariffs on every product imported from China if he has to. So far, the U.S. government has instituted $34 billion of tariffs on Chinese products, which was swiftly met with retaliatory levies by China.

Keep Emerging Market Exposure Light

So how much emerging market exposure should investors currently have? According to the Schwab market strategist, it should be in the small-single-digit range. For longer-term investors, emerging markets may be a more attractive bet. "Valuations are relatively low. There are few places in the market where you will find valuations in line or below the long-term earnings growth," Kleintop said.