Emerging Markets

By Nancy Zambell, BrokerAdviser.com | Feb 27, 2007 | comment

Emerging market mutual funds were hot in 2005, receiving a record $20.3 billion in inflows. But last year was even better, with inflows rising to $22.4 billion, according to Emerging Portfolio Fund Research. And the love hasn't stopped. 

The returns were also impressive. For 2006, Lipper lists an average return of 32% for emerging funds, while international funds gained 26% and domestic funds brought home 12%.

But the King of the Universe was China, the fastest-growing major economy in the world. The China economy has grown tenfold since foreign investments were first permitted in 1980. Last year, China-related funds accounted for one-half of emerging market inflows and seven of the top 10 gains in the MSCI Emerging Markets Index. Eight of the top ten mutual funds in the world last year centered on investments in the Chinese economy – returning stellar gains of 65% to 86%. And in Hong Kong, the Hang Seng China Enterprises Index of Hong Kong-listed mainland companies soared 94%.

The big impetus behind this phenomenal expansion: foreign direct investment and domestic consumer spending have surged.

In 2006, excluding the financial sector, foreign investment in China was up 4.4%, to $63.02 billion. During the past 5 years, wages in China have doubled. According to McKinsey & Co., per capita disposable incomes in towns and cities populated by more than 500 million people grew 10% in the first nine months of 2006.

But China is not the only big picture. The same study by McKinsey reported that the number of households in India earning an annual income of at least $10,000 is increasing more than 20% per year, while consumer lending grew 35% in the last two years. And auto and other big ticket item manufacturers saw price rises of 39% or better.

The growing wealth and their populations' willingness and ability to spend are expected to expand developing nations' economies by an average 19% in 2007, according to the UBS. That's almost triple the forecast for high-income countries.

Developing economies saw their share of total foreign direct investment climb from 18% to 36% from 1990-2005, led by Asia. China's share grew from $3.5 billion to $60 billion during that same period, while India's rose from $236 million to $5.3 billion.

Inveterate global investor Mark Mobius predicts that consumer spending from China to Brazil may keep returns of emerging market stocks at the top of the hill for the sixth consecutive year. Primary factors in this march to prosperity include:

• Interest rates in Brazil are the lowest in two decades
• The dollar-denominated Russia Trading System Index became the first developing country to top $1 trillion in market capitalization, soaring 71% in 2006
• Brazil's Bovepa Index  last year rose 45% in dollar terms
• Bombay's Sensitive Index likewise jumped 47%
• Peru's Lima General Index advanced more than any emerging market in 2006, tripling in value on surging exports of copper, gold and fishmeal, and reaching an 11-year high
• Merrill Lynch forecasts for the next quarter of a century, some 1 million people will move into towns or cities in developing countries looking for higher paying jobs, putting a strain on current infrastructure: Roads, public transportation and power generation. That will likely increase spending on those sectors by 43%, to some $1 trillion over the next three years.

The outsourcing trend has played a major role in jump-starting many emerging economies, particularly China and India. China has received a boom from manufacturing and India more from the customer service outsourcing sector. But Price-WaterhouseCoopers 10^th annual Global CEO Survey predicts that outsourcing is branching out even further, driven by the need to create global partnerships, not just cutting costs. Activities previously thought too important to send overseas are now being considered. Fully 12% of CEOs say they are prepared to outsource R&D, 11% are ready to send human resources tasks abroad and 9% plan to outsource sales and marketing functions.

MSCI's Emerging Markets Index, which tracks 25 markets in Asia, Eastern Europe, Latin America and the Middle East, set an all-time high last year of 912.65, posting four years of gains for the longest winning streak in its 19 year history. Big winners were China Life Insurance (LFC: NYSE), the country's biggest insurance firm, which almost quadrupled, and Russia's largest long distance telephone company, OAO Rostelecom (ROS: NYSE), which tripled.

The index is heavy on Asia, with 17% of equities from South Korea, Taiwan (11%), China and Russia (both 10%), South Africa (9%), Mexico (7%), and India (5%).

This year's forecasts for the index predict gains of as much as 10% to 15% -- not last year's stellar returns, but pretty darn good.

The silk road was definitely a path to prosperity for many investors last year. But the momentum became so frenzied that a pullback was inevitable. And while the stocks and funds have retraced somewhat, they can still be lofty.

According to UBS, while they are some 20% less expensive than those in developed countries, emerging market equities currently are the most expensive since 1999.

Colombia equities lead the pack at about 162 times earnings. India rates the most expensive among the largest of the developing nations, at around a 20.3 P/E, followed by Hong-Kong listed Chinese companies at 18.8 times. 

Added to the fairly elevated prices are the risks that I cited in last week's Financially Fit: economic and political instability, foreign exchange, and market. All of these must be taken into account when investing internationally.

Right now, pundits are sparring about new regulatory changes in China. Since the mid-1990s, China has aggressively courted foreign investment, which has significantly boosted its economic power in the world. Now the Chinese government is making noises about protecting its homeland companies from unfair competition, has raised interest rates and is selling U.S. Treasury bills to attempt to cool the economy.

eBay announced that it was closing its website in China, and Warner Bros. International Cinemas – after much ballyhoo about its huge expansion in China – suddenly reported that it was going to close its operations there. Yet the Chinese government is holding fast to its policy of gaige kaifang – reform and opening up that was initiated by Deng Xiaoping in 1979. 

The jury is still out, but most experts believe China will remain a fabulous opportunity for investors. It just pays to be a little cautious right now.

Instead, several emerging market pros are advocating heavier weightings in shares of South African, Egypt and Czech Republic companies, as well as Russia and Latin America.

Just remember: international investing is speculative and volatile. So please don't put a major proportion of your portfolio in any single stock, fund, ETF or ADR. Conservative thinking and diversification are of utmost importance.

Next week, we'll talk about the state of international investing in developed countries and I'll give you a list of funds and ETFs that may help you establish a portfolio with both emerging and developed markets as your base for global investing.

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