Emerging Markets have been on a hot streak so far in 2017. The question is, can it continue? In the first quarter alone, Emerging Markets (as measured by the MSCI EME) were up a formidable +13.9%, which put it far ahead of the performance of most U.S. Equities with the exception of the Technology sector, which was up a competitive +12.6%.

There is a ‘mean reversion’ argument for liking Emerging Markets equities right now. If you take a look at the last few years of performance, you will see that Emerging Markets have lagged behind most categories of U.S. stocks and developed market stocks. Leadership often changes hands in the global equities markets, so it stands to reason that Emerging Markets are due for a comeback.

If we go back to 2013, it’s easy to see how Emerging Markets have come up short on the performance front:

Category 2013 Performance 2014 Performance 2015 Performance 2016 Performance
Emerging Markets -2.3% -1.8% -14.6% +11.6%
Small-Cap US Stocks +38.8% +4.9% -4.4% +21.3%
Large-Cap US Stocks +32.4% +13.7% +1.4% +12%

Note: The following indices were used for each category. Emerging Markets: MSCI EM; Small-Cap US Stocks: Russell 2000; Large-Cap US Stocks: S&P 500

The disparity in performance is fairly plain to see. Emerging Markets has lagged, but that story could change in 2017. How is your investment portfolio positioned relative to Emerging Markets and foreign holdings?

Understanding Risks in Emerging Markets

Does this mean it’s time to go out and start loading up on Emerging Markets equities? No, it doesn’t. Investing in Emerging Markets can be a risky proposition, and investors should proceed with caution. Not all Emerging Markets companies are created equal, and when one invests in that space you need to be cautious about the political environment of the country where the company is domiciled (much corruption still persists in Emerging Markets), and also its general economic standing. That includes analysis of debt-to-GDP ratios, interest payments, credit spreads, and so forth. With thin information often characterizing developing countries, that can be a daunting task.

Macroeconomic pressures in the Emerging Markets space have subsided in the last year or so, as the global economy has continued to grow and Europe and China performed better than most expected. But it is important to note that the Emerging Markets fate rests tightly with how well the global economy performs, so any risks to global economic growth (negative U.S. policy, France leaving the European Union, China slowing) could have an outsized impact on Emerging Markets. Fortunately, as it stands now those major risks appear to be marginal, which should allow Emerging Markets to continue growing apace.

Fundamentals look pretty good in the space. Equities and particularly debt continue to benefit from stronger global growth and reflationary developed markets policies, and better fixed investment practices have helped to boost earnings growth and profitability. Earnings have been a sticky area for Emerging Markets of late, with weak growth rates posted over the last five years or so. 2017 could be a big year for a bounce back, with suggested emerging markets earnings perhaps improving by as much as 23% this year (compared to a measly +1.4% growth in 2015 and -2% contraction in 2016). As confidence re-enters the Emerging Markets space, it will be critical that they live up to these high earnings expectations. Time will tell.

Remember to Diversify

When allocating a portion of an investment portfolio to Emerging Markets, it is important to remember to diversify. Emerging Markets are inherently high risk, so it is important for investors to diversify some of that risk away where possible. Domestic U.S. assets are a good place to start.

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Disclosure

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts as an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

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Returns for each strategy and the corresponding Morningstar Universe reflect the annualized returns for the periods indicated. The Morningstar Universes used for comparative analysis are constructed by Morningstar (median performance) and data is provided to Zacks by Zephyr Style Advisor. The percentile ranking for each Zacks Strategy is based on the gross comparison for Zacks Strategies vs. the indicated universe rounded up to the nearest whole percentile. Other managers included in universe by Morningstar may exhibit style drift when compared to Zacks Investment Management portfolio. Neither Zacks Investment Management nor Zacks Investment Research has any affiliation with Morningstar. Neither Zacks Investment Management nor Zacks Investment Research had any influence of the process Morningstar used to determine this ranking.