Wall Street Journal
Investors have been piling out of emerging markets lately. It might be time to start tiptoeing back in.
While the world’s developed markets have rallied in 2011, emerging markets have slumped. The MSCI Emerging Market Index has dropped 3.5% this year, while the MSCI World Index, which tracks 24 developed markets, has jumped 5.1%. In fact, developed markets have beaten emerging markets for five consecutive months, the longest streak since the five months ended October 2008. What’s driving the trend? For starters, emerging economies, after two years of world-beating growth, are starting to face competition from the U.S. and other developed nations. The U.S. Federal Reserve, for instance, raised the low end of its 2011 growth forecast by 0.4 percentage point, to 3.4%, on Feb. 16. « Today, the emerging markets aren’t the only growth story in town, » says Kate Moore, senior global equity strategist at Bank of America Merrill Lynch Global Research in New York. Another factor spooking investors: inflation. The consumer price index in China jumped by 0.3 percentage point in January to 4.9%, above the central bank’s 4% target. Brazil saw a 0.8 point rise to 6%, while India’s CPI is mired above 8%. As central banks raise interest rates to slow price increases, investors fear that economic growth will slow as well.
Yet there is evidence to suggest that the move away from emerging markets has been too extreme. Despite the strains caused by inflation, emerging Asia is expected to generate about half of the growth in global gross domestic product in 2011, according to Barclays Capital. The bank projects that emerging markets will continue to outpace developed markets for at least the next decade. On a valuation basis, the recent selloff has made emerging-market stocks look downright cheap. Emerging-market price/earnings ratios are 16% lower, on average, than developed markets—the largest differential since the financial crisis. Emerging markets also are projected to have a higher dividend yield in 2011: 2.9% versus 2.6%, according to Citigroup Inc. « The valuations in emerging markets are getting interesting again, » says Geoffrey Dennis, global emerging-markets equity strategist at Citigroup in New York. « We’re telling our clients to buy. »
Michael Gavin, head of emerging-markets strategy at Barclays Capital, says emerging markets are poised to grow at a 10%-plus clip for the next decade, based on a forecasting tool called the dividend discount model, which uses earnings and dividend growth forecasts and other factors to project future stock prices. « The case for continued equity performance comparable to what we’ve seen during the past 10 years is strong, » Mr. Gavin says. Not that investors should overload their portfolios. Sam Katzman, chief investment officer at Constellation Wealth Advisors in New York, recommends that the typical investor place only 10% to 20% of their equity holdings in emerging markets. One mutual fund he uses for his clients’ portfolios is the institutional version of the Aberdeen Emerging Markets Fund, the top-ranked fund in its category for three-year performance, according to investment-research firm Morningstar Inc. Investors who want to bet on emerging markets but are afraid of the downside risks might also consider call options, which give the holder the right (but not the obligation) to buy shares in the future if prices rise. The selloff in emerging markets has made call options on the iShares MSCI Emerging Market Index exchange-traded fund relatively cheap, says Rebecca Cheong, head of global equity flow advisory in the U.S. at Société Générale in New York. Options prices are based largely on traders’ expectations of future price swings. Now, the MSCI Emerging Market call options are about the cheapest they have been since before the financial crisis, Ms. Cheong says. She recommends buying an April 48 call, which would cost about $79 for the right to buy 100 shares if the price rises above $48 (it now trades at about $46).
Another way to play emerging markets is via currencies. That is because currencies tend to rise when central banks are raising interest rates, as emerging-market central banks are doing now. And a more expensive currency has the added benefit of helping to stifle inflation. « When rates are rising, that’s the time to look at a country’s currency, » says Aaron Gurwitz, chief investment officer at Barclays Wealth. He recommends investors consider currency funds or short-term emerging-market debt. Morningstar says the Merk currency funds—which includes the Merk Asian Currency Fund—is one of the most reliable ways to play foreign currencies. One thing investors shouldn’t do, some advisers say, is use the selloff as an excuse to bail on emerging markets. Says Stephen Freedman, head of investment strategy at UBS Wealth Management Research: « This is a bump in the road in a very attractive story. »