One of the more startling developments of late has been the near-vertical recovery of emerging stock markets. Despite the collapse of those markets late last year, investors’ sentiment towards them has quickly switched from hate to love, with nothing in between.
Emerging markets have soared above almost all others this year, especially in the second quarter, even as those other markets were swiftly gaining altitude themselves. The outperformance carried a broad-based MSCI Barra index of shares in the developing world close to record highs, relative to the firm’s broadest index of stocks in mature economies, after touching a three-year comparative low late last year.
The rally provided an opportunity for shareholders in emerging-market funds to dig out of a very deep hole. The average portfolio specializing in them rose 35.1% in the second quarter, after falling 54.4% in 2008 and an additional 1.7% in the first quarter this year.
Corresponding second-quarter returns were 17.5% for domestic stock funds; 27% for funds investing in Europe and 27.8% for Asia funds.
Popular demand: The HDFC Bank Ltd building in Mumbai. The company has attracted overseas investor interest. Abhijit Bhatlekar / Bloomberg
You might think that after such stunning outperformance, investment advisers who comparison-shop would lighten up on emerging markets and spread the cash around mature markets. But they haven’t; the consensus seems to be that emerging markets remain the better bet, although it may be prudent not to place it just yet.
Investors trying to fathom the enormous run-up in emerging markets should have their minds on something else, as one portfolio manager sees it.
“The question to ask is: Why did they fall last year?” said Giles Conway-Gordon, co-chief investment officer at Cogo Wolf Asset Management Llc. in San Francisco. “That was the exceptional event, and now we’re seeing a return to normality in emerging markets.”
Many developing economies are enduring the global recession and financial crisis in relatively solid shape, and their stock markets suffered more than others through little fault of their own, international fund managers say. One factor was a sudden scarcity of credit that forced many Western investors to sell assets to raise cash.
“You had to sell what you owned, and that’s what everybody owned,” said John Maxwell, manager of the Ivy International Core fund.
One reason markets such as those of India, China and Brazil were so popular until the bear market is that sound government policy had become commonplace in the developing world. Officials “have learnt from past mistakes”, said Kirk Brown, who runs foreign portfolios in the American Beacon fund family. “Many of these markets are running surpluses, and inflation is under control.”
By contrast, fiscal and trade surpluses and other signs of sound economic management are hard to spot in many mature countries.
“We think there are serious question marks” about the long-term prospects of developed economies, Conway-Gordon said. “Growth is going to be uninspiring. Japan is a country in decline. Europe has not faced facts about its financial system and is over-bureaucratized.”
The ability to conduct business unfettered by the lingering effects of financial and economic imbalances should help emerging markets recover faster and keep a competitive edge, said Jason Hsu, chief investment officer at Research Affiliates, an asset management firm in California.
“Economies that won’t have to deleverage will consume more and employ more capital,” Hsu said. “That’s a definite positive. Those economies are going to be in positions of relative strength, and you’re going to see investment flow reacting to that.”
But doesn’t the rally mean that the reaction has already occurred? It’s possible that the choices open to international investors have been greatly curtailed—and that the low-hanging fruit, as well as a lot of the produce much higher up, has already been picked in emerging markets.
“When you see a great run like you’ve seen in emerging markets, you've got to ask whether you want to keep riding the ride,” Maxwell said. “You’ve got to be sure you’re going to come out of this in good shape” before buying at these levels, he advised. “I’m not 100% ready to bet on that at this point.”
The growth prospects he perceives for mature international economies, as well as the less dramatic yet sizeable rally they have already experienced, mean that they may not offer much of an alternative.
One approach Maxwell favours is buying companies in mature countries that do a lot of business in developing ones, such as Nestle SA, the Swiss food producer; Total SA, the French oil company; and Nissin Kogyo Co. Ltd, a Japanese company that makes car parts.
Others find emerging market stocks tempting, if pricey. Brown at American Beacon acknowledges that valuations appear somewhat stretched, but says he expects higher long-term earnings growth to remedy the condition. His largest holdings lately have included PetroChina Co. Ltd, HDFC Bank Ltd in India and Itau Unibanco Banco Multiplo SA, a Brazilian bank.
Harry Hartford, president of Causeway Funds Capital Management Llc. in Los Angeles, likewise foresees stronger earnings growth, although he would not be surprised by a pullback in the short run.
“I would argue that if you have anything other than a three-month investment horizon, you need to have emerging markets in your portfolio,” Hartford said. “It’s naive to think that a number of these markets will not continue to do well.”
Hsu expressed similar sentiments. “After they’ve gone up this far, we’re more than likely to see a larger correction,” he said. “But it’s hard not to argue that over a longer horizon they offer more opportunity and fewer problems to deal with.”
©2009/THE NEW YORK TIMES