By Ed Kuczma
When most baby boomers think about emerging markets, they think of currency devaluations, corruption, hyperinflation and boom to bust investment cycles. However the recent financial crisis has pointed out that the balance of risks in the world may be changing.
While it's true that emerging market indices declined more than indices that track developed markets during the depths of the financial crisis in 2008, stock markets in some of the largest emerging markets (such as the BRIC countries) have all returned at least 45 percent in U.S. dollar terms during the first six months of 2009. In fact, given the extent to which emerging markets have rebounded year-to-date, one could argue that the sell-off that occurred last year was overdone as investor's tolerance for risk declined.
Going forward, many baby boomers may use the perceived risks of emerging markets as an excuse not to invest in this asset class. However, it is possible that the risks of not having emerging market exposure in your portfolio may be even more damaging than the perceived emerging market risk, as you may miss out on the secular long-term growth opportunities.
Estimated GDP growth in emerging markets is forecasted to greatly outperform growth in developed markets for the foreseeable future. Higher unemployment rates and credit strained balance sheets in the U.S. and Europe makes for an uncertain outlook in terms of the speed and extent of recovery in the global economy. Given rapidly increasing per capita income levels and the relative under-penetration in consumer credit, it's unlikely that emerging markets will make up for a decline in developed market household consumption.
However, there is no doubt that the emerging middle class in the developing world will have an increasing propensity to consume going forward. In addition, the stark contrast in household savings rates, particularly between Asian and U.S. households, is a trend that appears to have been overextended and is ready for reversion. China has expressed interest in reducing investment in U.S. treasuries and diversifying to other methods of investment. One way that China could achieve this is by focusing future stimulus policy towards the development of pension, health care, education and unemployment protection. Increased investment towards these social programs would alleviate some of the burden off households to save for costly medical and educational programs. This is considered a fundamental solution to reducing Asian household savings rates, thus increasing domestic consumption.
In order to take advantage of the growing domestic demand within emerging markets, boomers may want to focus on small-cap emerging market stocks as they are more geared toward increasing domestic consumption within these markets. Expansionary fiscal and monetary policy across emerging markets has led to a reduction in taxes and reduced borrowing costs for small businesses and consumers. The combined effect is likely to lead to increased profits and higher disposable income. In addition, small-cap emerging market stocks have a more robust growth potential and are made up of more diverse industries compared to large caps. Large caps tend to be more cyclical in nature and their growth trajectory is generally more unpredictable.
Given the large rally so far this year, many baby boomers are rightly worried about an oncoming correction. While a near-term pullback may be warranted as investors look to book recent gains, I would view any short term dip in emerging markets as a buying opportunity.
With the comparatively higher growth rates and a more even balance in terms of potential sources of risk in the financial world, it is time that emerging markets become more of a mainstream investment option in boomer portfolios.
Ed Kuczma is part of the emerging market investment team at Van Eck Global. For more information, visit www.vaneck.com.