Emerging Markets--Is the Party Over?

By Nancy Zambell, Contributing Editor

Emerging market investments have been on a tear for the last few years, easily outpacing the returns of U.S. stocks. According to IFA.com, from Jan. 1, 2006 to May 31, 2008, while large U.S. stocks returned 6.8% a year, emerging market stocks earned an average of 25.4% annually.

And until the beginning of this year, many analysts and economists couldn't stop talking about the "decoupling" of emerging economies from U.S. and European markets. I heard the same thing at every financial show that I attended: emerging markets were no longer affected by the developed economies. But these gurus, perhaps, spoke too quickly.

This year hasn't been a very good one for most economies and stock markets — throughout the world. In the last 12 months, the S&P 500 index fell by 13%, but almost 8.5% of that decline occurred last month.

Meanwhile, emerging markets haven't fared much better. MSCI's emerging market index, EEM, lost 5% in the last month, and is down 9% for the year. But when you dissect the numbers further, we can see some very large disparities.
 

It's clear that not all emerging markets are alike. The primary reason for the positive returns in both Brazil and Russia is simply due to their commodity-based economies. As long as oil and other commodity prices continue to zoom ahead, these folks will probably do OK, unless inflation gets totally out of hand.

And that's the major reason why the remainder of the emerging markets didn't decouple -- the rising specter of inflation. As prices go up in one economy, all the other economies that do business with it are also affected.
 

• According to the latest figures from the National Bureau of Statistics, China's GDP grew by 10.4% in the first half of 2008, feeding fears of inflation, which is currently running 7.7%, despite Beijing's best efforts to regulate resource prices and to tighten its money supply.
   

• RBC Capital Markets reports that India has not been left out of that party, either, with a current annual inflation rate of 11.4%.
   

• The spread between emerging market bonds and U.S. Treasuries has widened by more than 50 basis points recently, another indicator of rising prices.
   

To blame are phenomenally-rising oil and food prices, as well as the weak dollar to which several Asian economies have been artificially pegged.

Inflationary fears are expected to continue to stymie the stock markets. But as I remarked above, the resource-rich economies of Russia, Brazil and other Latin America countries may be better insulated. As well, some of these latter regions have already begun to fight inflation, by raising interest rates and targeting strict inflation goals.

At the same time, markets may continue to be under pressure since growth around the world has sharply slowed and is expected to continue to decelerate the rest of this year before a gradual recovery in 2009.

However, the situation in the United States may be looking up -- at least temporarily. The U.S. markets' had a fairly good showing in the latter part of last week, resulting in a few pundits calling the end of the bear market, but overseas exchanges still suffered. And it's probably way too soon to call the end of the bear, which is creating havoc in some parts of the world.

After reaping the rewards from high flying stocks for so long (up 41% in 2007), the natives, globally, are now getting restless. Last week, more than 200 protestors attacked the Karachi Stock Exchange in Pakistan, forcing a temporary closure.

These kinds of protests may become even worse, which is why a few emerging markets have begun market stabilization measures. In China, for example, regulators are trying to stabilize local markets and India even went so far as to suspend futures trading in a selection of commodities.

Even in the U.S., regulators are talking about putting limits on short selling and curtailing speculation in oil.

Consequently, investors must continue to exercise prudence when choosing investments anywhere, but particularly in emerging markets.

As I've said before in these pages, international investing comes with special risks, including currency, economic, political, accounting and regulatory. It is essential -- especially if you are investing in individual stocks -- that you thoroughly do your homework to assess these risks and how they may affect your investments. For most investors, mutual funds and exchange-traded funds (ETFs) may be better options.

But, even if you only invest in funds and ETFs, it is also crucial that you become very knowledgeable of the economies in which you invest -- what products and services they offer, demographics, supply and demand factors, etc. That way, you won't be caught unaware should major economic cycles affect market behavior -- good or bad.

And lastly, I recommend that you keep any speculative investments (and yes, emerging markets are speculative) to a small portion of your portfolio. Additionally, spreading your risk among several countries and varying types of sectors within those countries will go a long way toward reducing your overall portfolio risk.

So, do your research, be prudent with the amount you invest, diversify and then you can have some fun going global!

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


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