From the December 2008 issue of Research Magazine • Subscribe!

December 1, 2008

Emerging-Markets Meltdown

It wasn't supposed to be like this.

Emerging market stocks were supposed be the future of capital growth. They were a source of spectacular gains. In fact, they were so invincible it was believed by some they were disconnected from the problems facing developed economies in Asia, Europe and the United States.

As it turns out, emerging markets are far more intertwined with the rest of the world than many of us realized.

From 2003 to mid-2008, the MSCI emerging markets index enjoyed annualized gains of 29.75 percent and outpaced U.S. stocks by a wide margin. Investors couldn't get enough. Back then, stocks from emerging economies led on the way up. Today, they're leading on the way down.

Broadly diversified funds like Vanguard's Emerging Markets ETF (VWO) and iShares Emerging Markets ETF (EEM) have lost about half their value this year. And ETFs following single emerging market countries have fallen about the same or more.

Emerging markets usually refers to countries whose financial markets and economies are still in development mode. Let's take a quick gander at what some of the world's largest emerging economies have been up to.

Brazil Major South American financial institutions like Banco do Brasil, Banco Bradesco and Itau haven't been spared from the global financial meltdown. Also, falling commodity prices and the prospects of a worldwide recession have many large commodity producers worried. The iShares MSCI Brazil ETF (EWZ) is down 49.5 percent this year.

ChinaChina's economy is slowing down much faster than analysts had predicted. While its financial system hasn't been hit as hard as those of Europe and the U.S., the global financial turmoil has dampened demand for its exports. China's central bank cut the benchmark one-year lending rate to 0.27 percent.

Since the beginning of the year, the iShares FTSE/Xinhau China 25 Index Fund (FXI) has declined 47.8 percent and the SPDR S&P China ETF (GXC) has fallen 50.3 percent. FXI follows a basket of 25 large-cap blue chips, whereas GXC contains a broader mix of large, mid-cap and smaller stocks.

IndiaIndia is another mega-emerging market that hasn't been spared. The value of real estate is falling, mortgage rates are rising and consumers aren't consuming. The same vicious deflationary environment that has afflicted the U.S. seems to be at work.

India's Reserve Bank reduced the cash-reserve ratio for banks in order to inject liquidity into the country's ailing banking system. The WisdomTree India Earnings ETF (EPI) has declined 51.5 percent this year.

RussiaRussia's stock market was closed several times as that nation's leaders scurried to devise a rescue plan. The Kremlin's $200 billion rescue package has done little to stop the downward spiral in stocks. Confounding Russia's problems is that Russian companies secured loans backed by inflated stocks as collateral. As stock prices fall, the collateral gets called in and stocks are sold at even lower prices. The Russia ETF (RSX) has sunk 65.7 percent this year.

Summary Even after their stunning fall, emerging markets remain an important asset class that all well-built portfolios should have exposure to. Investors who have seen their portfolios decline because of exposure to emerging markets shouldn't abandon ship.

If your clients overdosed on emerging markets, they should simply readjust their asset allocation. Periodic rebalancing can help to reduce future blow-ups. For others that never had exposure to emerging markets, now may be an excellent time to do some opportunistic buying.

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.

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