In this podcast, Jonathan Lemco of Vanguard Investment Strategy Group discusses the current state of emerging markets and how investors can use emerging markets to add diversification to their portfolio and offer the potential for growth.

Notes:
All investments are subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.
Securities based in emerging markets are subject to national, regional, political, and economic risks and the risk of currency fluctuations. These risks are especially high in emerging markets.
Investments in bonds are subject to interest rate, credit, and inflation risk.
The information presented in this podcast is intended for educational purposes only and does not take into consideration your personal circumstances or other factors that may be important in making investment decisions.
You may access and download this podcast only for your personal and noncommercial use. You may not use it in any other manner or for any other purpose without Vanguard’s written permission.


TRANSCRIPT

David Eldreth: Hello, and welcome to Vanguard’s Investment Commentary Podcast series. I’m Dave Eldreth. In this month’s episode, which we’re taping on June 16, 2016, we’ll discuss the state of emerging markets and how much investors should pay attention to the BRICS countries within that sector.

Jonathan Lemco, with Vanguard’s Investment Strategy Group, is here today to talk about what opportunities Vanguard sees in emerging markets overall.

Jonathan, thanks for joining us today.

Jonathan Lemco: Well, it’s a real pleasure to be here.

David Eldreth: Jonathan, many investors associate the acronym BRICS, spelled B-R-I-C-S, with emerging markets. Could you start by briefly explaining what we’re talking about when we refer to the term BRICS?

Jonathan Lemco: Well, BRICS was a term really first coined in 2001 referring to Brazil, Russia, India, China, or BRIC, and a couple of years later, South Africa was added to the mix. And what we’re talking about are essentially the largest developing countries in their continents.

David Eldreth: And we want to mention that we’re primarily talking about fixed income here, right, not stocks.

Jonathan Lemco: That’s right, because we’re looking at countries that issue bonds, as opposed to companies. So it’s a fixed income or bond perspective, mostly, looking at these sovereigns, as we call them, countries.

David Eldreth: Right. And are these five BRICS countries indicative of the overall emerging market sector?

Jonathan Lemco: Well, I suspect they’re a good representative sample, because they are so large within their continents. But the emerging market sector is not comprised only of these countries; there are many, many other EM countries that Vanguard invests in as well. They might include very small countries, the Uruguays of Latin America, Thailand or Philippines in Asia. They might include the Baltics of Eastern and Central Europe—Latvia, Lithuania, Estonia. All of these would also be considered emerging markets; all of these issue debt or, if you will, bonds, in our marketplace.

David Eldreth: That’s interesting. Now when you’re constructing a portfolio, what are the benefits to including emerging markets?

Jonathan Lemco: Well, first of all, they help to broaden diversification within a portfolio. The Vanguard view is that somewhere between 20 and 40% of a portfolio should be based on securities that are outside the borders of the United States. And of that 20 to 40, again depending on how much risk an investor is willing to take, emerging markets should comprise a portion, perhaps 25%, of that.

David Eldreth: Okay. Now all emerging markets aren’t created equal, right? I mean China and Brazil are both considered emerging markets, so there’s quite a bit of variance there. Now what factors should investors look at when considering emerging market opportunities?

Jonathan Lemco: Well, from a fundamental point of view, first of all, investors should pay attention to certain macroeconomic or even political considerations. On the macroeconomic side, a major consideration, possibly the most important of all, is to look at how well these countries manage their fiscal situation, their debt and their deficits. You don’t want to let this get out of hand, frankly. You want to demonstrate that you are a good credit risk, in part by managing your debt loads within a certain narrow range. If that is not the case, that, from an investor point of view, should be quite worrisome. A ratio like debt to GDP is one that we, as analysts, pay very careful attention to in that regard.

We also look at the extent to which these countries have built up their foreign currency reserves. China is an example of a country with over three trillion U.S. dollars or U.S. securities—treasuries, if you’d rather—in their central bank. Many countries in emerging markets—the Koreas, the Malaysias, the Thailands in Asia, the Mexicos and the Brazils, the Chiles in Latam [Latin America]—have built up vast storehouses of foreign currency reserves which are usually U.S. dollar but will almost always include, as well, euros or Japanese yen or Canadian loonies or the currencies of other very highly developed economies.

Now the point is by building up these reserves, they’re showing the investor community that they are money good. That when they issue bonds or debt, and we as investors buy that debt in the form of bonds, we have a very good sense that we will be repaid with interest because they have the money. We hope there’s a willingness to pay, but they certainly have the ability to pay.

It’s those countries that are in severe trouble today that cause us to worry—the Venezuelas right now, which have foreign currency reserves that are very low, the Ecuadors until recently, the Argentinas until recently. You’d be hard-pressed to find too many countries we call investable that have low amounts of foreign currency reserves.

David Eldreth: So an investor that’s looking for growth, how does that factor in?

Jonathan Lemco: At the moment, countries like India, China, Indonesia are growing faster than almost anywhere else in the world, although, particularly in the case of China, at a reduced pace than in the past.

China is an example of a country that year after year grew at 10%-plus growth. A consequence of that is that over 400 million people were elevated from poverty to the lower middle classes in China in the last 20-odd years. That’s the positive trickle-down effect of all that kind of growth.

David Eldreth: So you mentioned China’s economic slowdown. How is that impacting the overall sector on performance?

Jonathan Lemco: Well, in 2016, China is slowing down; 6.5, 6% growth, somewhere in that vicinity. It’s still faster than almost anywhere else. Not quite the same as it was, however. And we expect going forward that number will be pretty much the same. India is another example of a country growing rapidly as well, at about a 6-6.5% pace, maybe even better. So growth we care about.

Latin America by contrast, starting with Argentina and Brazil, is demonstrating anemic growth. Maybe negative growth. And that gets quite concerning. Eastern and Central Europe is somewhere in between.

We also care about political stability. Note, I’m not saying necessarily political democracy, although that is usually favored, but we want predictability. And that’s probably best guaranteed, at least in the short run, by stability. So we look at those countries that are managing to avoid civil wars and revolutions and unrest of one kind or another. That’s predictable. Predictability is key here.

Those are some of the factors that we would care about, at least from a fundamental point of view.

David Eldreth: And you talk about some of the opportunities within this sector. With opportunity, as you said, comes risk. Could you categorize or quantify the amount of risk that an investor will be taking if they weighed into this sector?

Jonathan Lemco: So bottom line is if you’re willing to accept some risk, the return can be high. You have to live with the volatility. You have to have a bit of a long-term perspective. That’s part of the deal.

Most of what we invest in, although not all, is predominantly investment grade, that is, it’s triple B- and up. To the extent that that’s true, history teaches us that the overwhelming majority of these countries involved have not defaulted either in a very long time or at all. Therefore, it’s very likely money good.

The risk is the volatility you deal with. To the extent that it includes some countries that are junk rated, that is, below triple B-, according to the credit rating agencies, you expect a bit higher return, but you’re taking a bit more risk there, too.

That said, our funds tend to be very large, comprised of many, many of these countries at a time, sometimes mixed with bonds from other sectors as well. So what the investor enjoys as a result is a broad degree of diversification. There’s no one risk in any one place. In the unlikely event of a default somewhere, there are many, many other credits that are doing reasonably well.

David Eldreth: Okay, great. Well, Jonathan, thanks for being with us today. We appreciate your time and your insights on this topic.

Jonathan Lemco: Well, it’s been my pleasure. Thank you.

David Eldreth: And thank you for joining us for this Vanguard Investment Commentary Podcast. Be sure to check back with us each month for more insights into the markets and investing. And, remember, you can always follow us on Twitter. Thanks for listening.

Important information

For more information about Vanguard funds and Vanguard ETF Shares, visit advisors.vanguard. com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

All investments are subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.

Securities based in emerging markets are subject to national, regional, political, and economic risks and the risk of currency fluctuations. These risks are especially high in emerging markets.

Investments in bonds are subject to interest rate, credit, and inflation risk.

The information presented in this podcast is intended for educational purposes only and does not take into consideration your personal circumstances or other factors that may be important in making investment decisions.

You may access and download this podcast only for your personal and noncommercial use. You may not use it in any other manner or for any other purpose without Vanguard’s written permission.

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