After a miserable 2008, emerging-market stocks have caught fire this year. And their rally has plenty of room to run.
Certainly, the rally itself is no surprise; most asset classes have moved up sharply in recent months. But while most have recently paused amid concerns that investor exuberance may be overdone, emerging markets roll on.
The average emerging-market mutual fund shot up 7.9% in the 30 days that ended June 18, roughly twice the gain recorded by large-capitalization U.S. stocks, according to Morningstar. That brings year-to-date emerging-market gains to 30.8%, compared with 3.9% for domestic big-cap stocks.
The forecasts clearly favor the markets of developing nations. "We will see much greater and much more rapidly developing growth in the emerging markets as compared to mature markets like the United States, developed Europe and Japan," says Eric Bjorgen of Leuthold Group asset managers in Minneapolis.
In May, Leuthold boosted its position in emerging-market stocks to 21% of total assets in what it calls core portfolios, an all-time high and more than half again the highest prior level of 13% in 2003. That's a huge statement of confidence.
Yet despite their run-up, stock prices in developing markets are relatively low. And with 150 mutual funds available in this group, it's easy for the everyday investor to buy in. You don't have to, say, try to pick the best retail stock in China or the best coffee play in Brazil, two of the larger emerging markets.
There's one possible hurdle, though: Some 401k's and other retirement plans do not offer emerging-market options, judging the group to be too risky. If your plan doesn't, consider opening an individual retirement account that does provide access. Excellent funds are abundant.
A premium on growth
Constantine Papageorgiou, one of the managers of Acadian Emerging Markets (AEMGX), cites three reasons developing countries are likely to experience more-rapid growth than the developed world."Number one, these countries are running surpluses rather than deficits," he notes. "Secondly, we've seen the emergence of sizable and strong consumer classes that could carry these emerging markets through recent turbulence. Third, you have positive exposure to commodities and energy prices."
China, by far the largest emerging market, has been racking up economic gains in double digits for more than a decade and is expected to continue to outpace its rivals this year and next.
Higher growth usually justifies premium prices for stocks. But emerging markets got taken to the woodshed last year as investors ran away from risk. The average emerging-market mutual fund plunged 54.4%.
So instead of a premium, stocks of this group are selling at a discount. According to Morgan Stanley Capital International, the average ratio of stock price to earnings is 13.7 in emerging markets, compared with 18.5 in the United States.
Buying the BRIC
One of the fastest-growing types of emerging-markets fund restricts investments to the so-called BRIC nations -- Brazil, Russia, India and China. The rationale is that these are the largest and most economically important emerging nations. They also are strong trading partners among themselves.Their stocks are correspondingly zippier than those of their rivals. The Claymore/BNY Mellon BRIC (EEB) exchange-traded fund was up 37.7% this year, as of June 16, compared with the 26.9% gain of the broader iShares MSCI Emerging Markets Index (EEM).
But this hyper-performance cuts both ways. In last year's rout, the Claymore fund plunged 54.8%, even more than the 48.9% collapse of the iShares fund.
So most investors will probably be more comfortable owning a diversified emerging-market fund rather than a BRIC fund. The former have most of the advantages of the more specialized portfolio -- BRIC countries are four of the seven largest holdings of the MSCI index -- plus they capture the semiconductor industry of Taiwan and the consumer-products sector in South Korea.
One other option for getting exposure to these markets is bond funds. Morningstar counts 31 funds dedicated to emerging markets, including Fidelity New Markets Income (FNMIX), Pimco Emerging Markets Bond (PEBIX) and T. Rowe Price Emerging Markets BondPREMX). (
These bonds, the sovereign debt of emerging nations, on average are investment grade, if only barely, and offer yields in the high single digits and total returns in the low double digits, but with less than half the risk of equities.
Who should play
Indeed, as Acadian's Papageorgiou says, emerging countries these days are apt to have better balance sheets than their developed brethren. Only a handful of backwater regimes, such as Venezuela's, openly flout the rule of economic law, while deficits in the U.S. zoom to levels, as a percentage of gross domestic product, not seen since World War II.In a reversal that Richard Nixon could scarcely have imagined when he reopened relations with China in 1972, the U.S. has been publicly warned by those same Chinese communists to tighten the reins on its monetary policy, lest inflation result from excess economic stimulus -- and endanger China's vast holdings of U.S. Treasury bonds.
Despite the positives, however, emerging markets continue to be riskier than those of developed nations. So conservative investors will want only a small position and possibly only the bonded debt.
Aggressive investors, though, should embrace emerging markets with enthusiasm. And especially now, when everything else looks so dicey.
At the time of publication, Tim Middleton owned shares of the following funds mentioned in this column: Acadian Emerging Markets, Claymore/BNY Mellon BRIC and T. Rowe Price Emerging Markets Bond.