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Emerging Markets: Time to Invest?

Given the extent of deterioration in the global economic outlook in recent months, it may be a surprise to learn that there are still emerging markets worth a look for investors. If there's one mind-set prospective investors in emerging markets should have this year—or perhaps the next two years—it's aggressive patience. Yes, these markets are volatile and highly correlated to the U.S. and other developed markets at the moment, but over time the fundamentals, especially growth rates above those of the developed world, in these countries will reassert themselves.

Let's be clear: Emerging or developed, most markets around the globe have suffered in the downturn. A select few individual stocks such as Wal-Mart (WMT) have managed to resist the overwhelming downward spiral in asset prices since the beginning of this year, but all broad markets have been adversely affected. For investors who need to live on their retirement savings and are trying to preserve what remains of it, only cash and relatively short-duration U.S. Treasury bonds will let them sleep at night.

But for the rest of us with at least a few years until retirement, who are committed to long-term investing goals, it's a matter of choosing the markets whose losses have been smaller than others.

Financials Bog Down Eastern Europe

The Russell Emerging Markets Index was down about 12% year-to-date as of Feb. 27 vs. a 17.4% decline in the Russell Developed Markets index over the same period. One theory as to why emerging markets have performed better this year is that they experienced a much bigger decline last fall than developed markets did. Investors need to be careful, however, in view of the considerable disparity that exists between larger and stronger markets, such as China and Brazil, and smaller, weaker ones such as most countries in Eastern Europe.

A shared weakness among the smaller and worst-performing countries is that their economies are overweight in financial stocks and underweight in energy and technology names, says Rob Balkema. a portfolio analyst at Russell Investments. Financials represent 67% of Romania's stock index, 39% of Poland's, and 37% of Bulgaria's, compared with 20% of Brazil's, he says. Energy and technology stocks make up 27% of Brazil's country index and 21% of China's, yet have a zero weight in Bulgaria's index, he says.

Eastern European stocks have come under additional pressure this week, after European Union leaders rejected a request for a multibillion euro bailout for the region on Mar. 1, in response to sharp declines in a number of local currencies.

Solid Banking Stocks in Some Markets

A modest allocation to emerging market stocks is still appropriate, but investors need to recognize that the global economy continues to face major headwinds and that earnings downgrades are likely to accelerate, says George Hoguet, an investment strategist at State Street Global Advisors (STTT) in Boston. Not least among the headwinds is additional write-offs of soured assets in the banking system that could approach $1 trillion, he adds.

Banks in emerging markets have remained strong for the most part due to simple banking models, fairly good capitalization, and lower debt-to-deposit ratios, having avoided overlending in recent years. Their chief advantage over their counterparts in developed economies is their much smaller exposure to toxic financial products, says Nick Beecroft, portfolio specialist at T. Rowe Price International (TROW) in London. A key exception are the banks in Eastern Europe, where rising debt levels have been exacerbated by falling currency values, making it that much harder to repay the foreign debt they owe, says Russell's Balkema.

Still, that's not necessarily a rationale for staying away from emerging markets. Helen Modly, executive vice-president at Focus Wealth Management in Middleburg, Va., says she believes the U.S. needs to recover before emerging markets can, but "since we normally keep a fairly low weighting in emerging markets, about 3% to 5%, we're letting our positions ride for right now vs. selling them out."

A Chance to Buy In at the Bottom

Nick Chaime, head of emerging markets research at RBC Capital Markets (RBC) in Toronto, is focused on the short term and predicts near-zero growth for emerging markets as a whole this year, with economic contraction in most countries being offset only by continued growth in China. But growth in China is now expected to fall to 6.5%, half its pace in 2007. And even China's expected growth will be largely a function of the country's huge fiscal stimulus package, estimated at 7% of its gross domestic product, to be spread over the next two and a half years, says Chaime.

Taking the longer-term perspective makes Beecroft at T. Rowe Price more optimistic. He believes long-term investors will be able to look back three years from now at 2009 as a great opportunity in these markets.

"Whether you have missed the boat in the 2003-2007 period, or if your emerging markets exposure is underweight currently, if you're prepared to be patient, 2009 represents a good long-term opportunity to enter the asset class," he says. Still, these markets may well still revisit the lows they reached in October before this year is out and Beecroft is unwilling to call a bottom, given the extreme volatility.

"We think investors should be gradually adding to their exposure over time to counteract that volatility," he says. He recommends investing money with active managers whose expertise is in seeking out high-quality companies—managers whose portfolios performed quite badly last year when the market traded on macroeconomic news flows and general risk-aversion tendencies instead of on company-specific fundamentals.

Stick with the BRICs

The Big Three emerging market countries—Brazil, China, and India, the so-called BRICs—appear to be best-equipped to weather the global downturn. Still, there is growing uncertainty about whether China's growth rate in 2009 will fall below 6.5%, which would signal a recession in Chinese terms, says Hoguet at State Street. He predicts China will be able to avoid a recession thanks to its flexible fiscal policies and a massive $2 trillion in reserves, which provides the ability to fund an effective economic stimulus program. He's more concerned about some Asian exporters such as Taiwan, which has relied heavily on consumer demand from the U.S. and Europe and has also made big investments in production capacity and the acquisition of substantial foreign exchange reserves.

Indian stocks are always slightly more expensive than stocks in other parts of Asia, as Indian companies tend to be more profitable and deliver slightly higher returns on equity than neighboring countries, says Beecroft. But the average price-to-book in India is currently around 1.5 times 2010 estimated book value, near the lower end of its historic range, which is fairly attractive he says. Price-to-book is a more reliable measure of value at a time when earnings estimates are so fluid.

Investors need to guard against prejudices based on false assumptions. For example, while demand for oil and basic materials has dropped sharply, agricultural commodities such as the ones produced in Brazil have been less vulnerable to the economic downturn, says Will Landers, who manages the BlackRock Latin America Fund and Emerging Markets Fund (MDLTX). Brazil's banking system is solid, with very manageable debt levels, and growth in domestic loans to consumers and businesses, Landers says, and auto production grew for the third consecutive month in February. Brazilian stocks now account for 72% of the assets in the BlackRock Latin America Fund, up from the high-60% area at the end of 2008.

Your willingness to stick a toe or a foot back into emerging markets while global economic conditions remain so uncertain may come down to your view of valuations, which depends on how corporate earnings fare over the next two years.

Although stock valuations have at times in past economic cycles been cheaper than the current nine times 2009 estimated earnings, "for the long-term investor, this is not an unattractive point to enter emerging markets," says Hoguet. "But I think that given the high correlation of emerging markets with developed markets, and particularly the U.S., further weakness in the U.S. would likely lead to a sell-off in emerging markets. There may be a more attractive entry point in the next two or three months."

Bogoslaw is a reporter for BusinessWeek's Investing channel.

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

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