Markets & Finance

Emerging Markets: Irrationally Exuberant?


They're red hot again, but historically emerging markets have been dictated by money flows and give back nearly all of their gains. Is this time different?

Emerging markets are getting frothy. While developing world equities have advanced just under 50% this year, markets in China (+84%), India (+64%) and Peru (+109%), to name a few, are trading at 52-week highs. In the eyes of some observers, the Chinese stock market resembles the dot-com boom of the late 1990s, with initial public offerings jumping out of the gate. One IPO—Sichuan Expressway—surged 300% on its first day of trading.

It's clear that emerging markets will likely be the source of global growth for years to come. Emerging markets now account for 50% of world gross domestic product. While the developed economies are busy reducing debt, salvaging their banking systems and looking forward to slow growth (at best), many developing countries (excluding ones in Eastern Europe and Russia, of course) are sitting on piles of cash and have sound banks and moderate growth.

But does that warrant these outsize returns? "It's hard to refute the case that emerging markets will be the fastest-growing economies in the world," says Bob Phillips, the managing partner at Spectrum Management Group in Indianapolis. "But that doesn't mean they'll always go up." Investors should keep that in mind as they rush into emerging markets.

And rush they have. According to EPFR, a mutual fund flow tracker, emerging markets have seen inflows of $32 billion this year, outpacing developed markets. But if the flows reverse, watch out. Historically, emerging-market booms have been driven by available cash. Money rushes in and the stock markets hit new highs. Then investors turn on a dime and the money rushes out. The end result: Emerging markets tend to give up nearly 100% of their gains. In 1991, $1 invested rose to $2 by 1994, but by 1998 it was worth a dollar again. In 1999 that $1 was back to $2. In 2001 it fell to $1.10. A dollar invested in May 2005 became $3 in 2007, but retreated to a dollar again in 2008, all dominated by fickle investor cash. "Money flows will dominate, not the underlying fundamentals," Phillips says.

Developing Nations Are Awash in Cash

This global recession, however, may have upended the status quo. In previous downturns, emerging-market booms ended when problems cropped up—in emerging markets. Russia's debt default in 1998, for instance, spurred a run on developing markets. This time, however, the problems originated in the developed world and have left Asia and South America (relatively) unscathed. Furthermore, during past busts developing nations ran enormous deficits. This time around they hold trillions of dollars in cash reserves. Yet, U.S. and European investors continue to see the world through their own perspective. "The bubble is actually in the developed world," says Jerome Booth, head of research at Ashmore Investment Management. "That's where the deleveraging has to occur."

So what's an investor to do? One option: Avoid emerging-market stocks in favor of bonds. When looking overseas, most investors assume they have to buy stocks—the most volatile asset available, Booth says. A Brazilian bond, however, pays a coupon of around 10, and won't fluctuate nearly as much as stocks. He also recommends doing away with the entire BRICs concept when investing in emerging-market equities. "You should invest in 64 countries, not four," Booth says. "That's how you avoid bubbles."

Another option is to anchor the emerging-market portfolio with another, less volatile asset class. That means taking 50% of the money you've earmarked for emerging markets and putting it into cash. The other half goes into an emerging-market index fund or exchange-traded fund. Every month the allocation should be rebalanced back to a 50-50 split. Over time, Phillips says, that strategy has produced 75% of the returns with half the volatility. More aggressive investors can replace the cash with the iShares MSCI EAFE exchange-traded fund (EFA), which invests in global developed markets, says Tom Wilson, a managing director in Brinker Capital's institutional investment and private client group.

When done right, each strategy will provide investors a margin of safety. Ronald Florance, director of asset allocation and strategy at Wells Fargo Private Bank (WFC), prefers rebalancing when the emerging-market asset allocation gets out of whack by five percentage points or more, rather than on a monthly basis. "Emerging markets are like cayenne pepper—a little bit in the soup is great," says Florance. "Too much is a disaster."Emerging markets are getting frothy. While developing world equities have advanced just under 50% this year, markets in China (+84%), India (+64%) and Peru (+109%), to name a few, are trading at 52-week highs. In the eyes of some observers, the Chinese stock market resembles the dot-com boom of the late 1990s, with initial public offerings jumping out of the gate. One IPO—Sichuan Expressway—surged 300% on its first day of trading.

It's clear that emerging markets will likely be the source of global growth for years to come. Emerging markets now account for 50% of world gross domestic product. While the developed economies are busy reducing debt, salvaging their banking systems and looking forward to slow growth (at best), many developing countries (excluding ones in Eastern Europe and Russia, of course) are sitting on piles of cash and have sound banks and moderate growth.

But does that warrant these outsize returns? "It's hard to refute the case that emerging markets will be the fastest-growing economies in the world," says Bob Phillips, the managing partner at Spectrum Management Group in Indianapolis. "But that doesn't mean they'll always go up." Investors should keep that in mind as they rush into emerging markets.

And rush they have. According to EPFR, a mutual fund flow tracker, emerging markets have seen inflows of $32 billion this year, outpacing developed markets. But if the flows reverse, watch out. Historically, emerging-market booms have been driven by available cash. Money rushes in and the stock markets hit new highs. Then investors turn on a dime and the money rushes out. The end result: Emerging markets tend to give up nearly 100% of their gains. In 1991, $1 invested rose to $2 by 1994, but by 1998 it was worth a dollar again. In 1999 that $1 was back to $2. In 2001 it fell to $1.10. A dollar invested in May 2005 became $3 in 2007, but retreated to a dollar again in 2008, all dominated by fickle investor cash. "Money flows will dominate, not the underlying fundamentals," Phillips says.

Developing Nations Are Awash in Cash

This global recession, however, may have upended the status quo. In previous downturns, emerging-market booms ended when problems cropped up—in emerging markets. Russia's debt default in 1998, for instance, spurred a run on developing markets. This time, however, the problems originated in the developed world and have left Asia and South America (relatively) unscathed. Furthermore, during past busts developing nations ran enormous deficits. This time around they hold trillions of dollars in cash reserves. Yet, U.S. and European investors continue to see the world through their own perspective. "The bubble is actually in the developed world," says Jerome Booth, head of research at Ashmore Investment Management. "That's where the deleveraging has to occur."

So what's an investor to do? One option: Avoid emerging-market stocks in favor of bonds. When looking overseas, most investors assume they have to buy stocks—the most volatile asset available, Booth says. A Brazilian bond, however, pays a coupon of around 10, and won't fluctuate nearly as much as stocks. He also recommends doing away with the entire BRICs concept when investing in emerging-market equities. "You should invest in 64 countries, not four," Booth says. "That's how you avoid bubbles."

Another option is to anchor the emerging-market portfolio with another, less volatile asset class. That means taking 50% of the money you've earmarked for emerging markets and putting it into cash. The other half goes into an emerging-market index fund or exchange-traded fund. Every month the allocation should be rebalanced back to a 50-50 split. Over time, Phillips says, that strategy has produced 75% of the returns with half the volatility. More aggressive investors can replace the cash with the iShares MSCI EAFE exchange-traded fund (EFA), which invests in global developed markets, says Tom Wilson, a managing director in Brinker Capital's institutional investment and private client group.

When done right, each strategy will provide investors a margin of safety. Ronald Florance, director of asset allocation and strategy at Wells Fargo Private Bank (WFC), prefers rebalancing when the emerging-market asset allocation gets out of whack by five percentage points or more, rather than on a monthly basis. "Emerging markets are like cayenne pepper—a little bit in the soup is great," says Florance. "Too much is a disaster."


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