For the past three years, emerging markets have been on a tear.
From March 24, 2003 to the same day this year the average annual increase for emerging markets was more than double that of domestic markets; they have grown 44.6 percent (as measured by the MSCI Emerging Markets Index) compared with 18.6 percent for U.S. stocks, as measured by the broad-based Russell 3000 Index.
This year alone, emerging markets were up 10 percent by March 24; U.S. stocks were up 5.6 percent. Technical indicators point to the strong performance continuing this year.
But sharp increases in oil prices or unforeseen geopolitical events might introduce new elements that investors cannot anticipate and which might increase market volatility and depress emerging market stocks.
Investors, therefore, have to balance risk and the potential reward in deciding how much of their portfolios to allocate to emerging markets.
On the positive side, the gains last year reflect strong markets in countries such as Egypt (up 154.5 percent in U.S. dollars last year), Colombia (102.3 percent), Jordan (71.7 percent), Pakistan (56.5 percent) and Brazil (50 percent). The overall gains, in return, reflect strong economic growth, with the emerging countries growing on average twice as fast as the developed countries since 2001. Many of these emerging countries have current account surpluses whereas in the past they would have had deficits.
Managers point out that fundamental indicators are positive. Earnings in the emerging countries have grown in double digits, averaging 25 percent in 2004 and 10.5 percent last year. Return-on-equity has almost doubled from 11 percent to 19 percent since 1999. Dramatic improvements have been shown in the health of corporate balance sheets, achieved through earnings growth and debt reduction. An enhanced regulatory environment, improved corporate governance and greater liquidity have started to occur in many of the emerging countries.
A result: Many emerging market debt issues now have a better overall credit rating than General Motors and Ford.
Many managers who follow these markets believe that demographic trends and continuing improvement in the countries’ current and fiscal accounts point to continued growth in the emerging countries compared with the U.S. and other developed nations.
As a result, many remain bullish on the outlook for the emerging markets over the next year. Some 45 percent of respondents to the most recent Russell Investment Manager Outlook survey, for example, were bullish on the emerging markets, placing this asset class ahead of all classes of U.S. value stocks, real estate investments and fixed income in degree of bullishness.
Another factor is that investors’ bullishness could, for a while, be a self-fulfilling prophecy. The favorable image that investors have of emerging markets might serve to keep them investing, thereby pushing the markets ahead, even should economic events begin to turn against them.
If such a phenomenon occurs, it could reflect the “irrational exuberance” that kept the U.S. technology stocks gaining strongly for additional years before its fall from grace in 2000.
On the other hand, there is always the chance that 2006 might see sharp sell-offs in the emerging markets.
Among the risks that lie ahead is an approaching election cycle that could bring about political change in eight countries that face elections; should a country elect a new government, the new regime might reverse trends toward market deregulation and might set back laws that have created favorable business climates.
Another risk is the price of oil. Should it gain strongly, countries such as India, China and Thailand will be hard hit as a large percentage of their economies are dependent on oil imports.
Shifts in currency exchange rates also could work against, as well as in favor of, investments in the emerging countries.
Some managers also fear the impact that increasing investments could have on some of the emerging countries, where local markets might not have the ability to handle the flood of capital pouring into individual stocks and the money might not be put to the best use.
Another fear is that, should these markets begin to cool, investors – who have been looking to this asset class for large returns – might withdraw, possibly resulting in a rapid outflow of capital and a reduction in liquidity.
As always, investors should avoid making new investments on the basis of what happened last year or the previous three or even five years. Because the emerging markets historically have been cyclical, we can never be sure how long a trend will continue.