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Monday, May 16, 2011 - 13:00
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Thursday, August 15, 2013 - 11:09
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Monday, May 16, 2011 - 13:00

Should You Still Invest in Emerging Markets?

Monday, May 16, 2011 1:00 PM

In the past few years, the global investment landscape has undergone massive change. Some of the smallest and riskiest economies saw their stock markets soar, in many instances exceeding the quite impressive gains secured in the United States. As I noted back in December, some stock markets roughly tripled in value in just two years.

The go-go era of emerging-market investing has come to an abrupt halt. Not a single stock market outside of Europe has risen even 10% this year. And some formerly hot emerging markets such as India and Peru are off by more than 10%.


The fact that European stock markets have been top gainers thus far in 2011 comes as a bit of a surprise. After all, the European Union is still wrestling with potential debt bombs in places like Greece and Portugal and voices calling for dissolution of the euro currency have not grown any quieter. But investors are willing to give some credit for a degree of corporate belt-tightening underway, and if the currency crisis can be tamed, these markets could rise yet further, as many European small and mid-caps still carry valuations below those seen before the crisis.

To my mind, all of the countries in the left-hand column of the table are highly-correlated with each other and with the United States, with the exception of Poland, South Korea and Malaysia. Each of those countries have worked to develop strong economic infrastructures, which is a precursor to an extended run of sustained growth, as Japan saw in the 1960s, 1970s and 1980s. (South Korea is clearly well along in that multi-decade growth phase.)

The fact that these European bourses have outperformed our own is a bit misleading. The euro has gained roughly 7% against the dollar since the start of the year, and if you back out that factor, European and American market indexes would look quite similar. Suffice it to say, future relative performance between the two continents may be dictated by currency moves. And that may come down to which region more aggressively hikes interest rates in coming years. Europe got the early start with recent rate hikes, but it's still unclear which region will have higher rates (and thus a firmer currency) a year or two from now.

Risk and return
Many of the countries listed on the right-handed column are classic "emerging market" plays. After most of these countries posted torrid gains in the past few years, few should be surprised that they are being hit by profit-taking in 2011. The question for investors is whether this just a speed bump or the start of a real problem. Let's look at a few examples...

Brazil
The economic powerhouse of South America is learning a hard lesson: it's hard to manage policy and trade when your currency is on steroids. The Brazilian real has risen from around 0.40 against the dollar to a recent 0.61 -- a 50% move. The surging real means exports are becoming less competitive, imports are becoming more expensive, and inflation pressures are forcing the government to slam on the brakes. Brazil's central bank has hiked rates three times already in 2011, and the benchmark lending rate now stands at 12.0%. Perversely, the fight to control inflation by hiking rates is attracting even more global investors into the currency, making it even stronger.

The goal of Brazil's policy makers is to engineer a soft landing whereby inflation pressures recede but economic activity stays firm. That's a hard -- though not impossible -- act to pull off. While it plays out, investors are better off avoiding Brazilian investments right now. The country's long-term growth prospects remain quite bright, and a steady drop in inflationary pressures would turn on the green light for investors.

The Middle East
About six weeks ago, I cautioned investors to steer clear of Egypt-related investments, as that country's economic and political environment may weaken before it strengthens. At the time, I reiterated my view that Turkey provides much of the exposure you'll really ever need to the Middle East.

In addition to a very advantageous locale with respect to trade, Turkey's finances are in very sound order, inflation is almost non-existent and recent heavy investments in infrastructure could enable the economy to handle much higher trade volume without hitting bottlenecks.

India
One of the world's most populous country is also its most vexing. India possesses a tremendous amount of intellectual capital relative to their size of the economy, but applying that capital to help build a foundation for growth has proved vexing. Poverty remains intractable, infrastructure is dismal, and the political leadership is sclerotic. Yet if India came anywhere close to realizing its potential, then the country could prove to have one of the most dynamic investment climates in the world. The 14% drop in the iPath MSCI India Index ETN (NYSE: INP) fund so far this year shouldn't lure you in just yet. Instead, dedicate time periodically to see what kind of progress the country is making. In a matter of a year or two, the stage could truly be set for sustained economic growth. A stock market boom would follow.

Action to Take --> A key catalyst for investors in these countries is a falling dollar, which amplifies the returns of any foreign-based investments. Assuming the dollar doesn't move much from its current range, it's unclear how European exposure will provide the diversification your portfolio really needs. South America, Africa, the Middle East and Asia are really the areas to focus on if you want to get a stake in more dynamic long-term opportunities.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.