Emerging Markets: Time to Invest?

Major emerging-market indexes outperformed developed market benchmarks in February, but slowing growth could still spell trouble for stocks in these regions

By David Bogoslaw

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."