Comment: Emerging markets – a time to invest?

Emerging markets performed spectacularly in the early 1990s but since then they have proven to be a disappointment to investors, with poor returns coupled with increased volatility.

The asset class has experienced one crisis after another; devaluations and financial crises have had an adverse effect on portfolio returns.

Up to September 2001, the US had experienced its longest bull market in history and while the S&P500 more than doubled its index value, the emerging markets index value lost almost half.

More recently, emerging markets have held their value better than developed markets, declining to a lesser extent.

Emerging markets have a predisposition for long-term growth, as they are generally larger industrialising economies that have improving infrastructure.

Developing markets are starting to drop the failed economic models that characterised previous crises, largely based on loose lending by banks, high consumer savings and poor investment by corporations, and moving towards implementing free market models, thus increasing transparency.

Increased liquidity and market sentiment in the US can help emerging markets lever off a US upturn by stimulating capital inflows and boosting their exports.

The exports of emerging markets benefit from the sharp increase in US consumer spending that is typical of recoveries, through a competitive exchange rate and competitive wages.

Because the GDP of these developing markets is largely generated by exports, when spending picks up in the US, this is usually good news for emerging markets.

Consumer spending in the US remained robust throughout the downturn and this may mean that any rally off the upturn could be less pronounced.

In the fight against terrorism, the US has recently increased aid to a number of developing countries, such as Egypt.

The developed world is beginning to realise that terrorism is a consequence of economic instability and the strengthening relationship between the US and these emerging markets could lead to improved performances through increased awareness and capital inflows.

Many of the crises experienced by emerging markets have been related to a fixed currency, and this is no longer a common feature of emerging markets. Most developing countries now have free-floating currencies with only a small few, China and Malaysia for example, maintaining a fixed exchange rate.

Emerging markets tend to be one of the first asset classes to rally with an impending upturn and are cheaper than comparable assets in developed markets. Investing into emerging markets can be risky but paradoxically, when added to a portfolio, they reduce risk to a greater degree than most other asset classes.

This is due to low correlation (the extent to which they move together) between emerging markets and developed markets, and history has shown that when one is booming the other can be suffering.

The two markets move for very different reasons and this is important in an environment where developed market correlations are increasing and thus diversification benefits are being eroded.

Korea has been the best performing emerging market of late in a time where the US is looking bearish, but even with its higher volatility, having Korea in your portfolio would radically reduce the overall risk.

An investor must keep in mind however, that even with low correlation, the US is such a dominant feature of the world economy that if it falls hard, it can still take the rest of the world with it.

The cultural, political, legal and economic differences between emerging and developed markets can make investing hazardous. The fundamentals look good for emerging markets, but as always, future performances are not guaranteed.

- FUNDSOURCE