Increased Opportunities in the Emerging Markets

As the financial crisis struck the U.S. markets in the second half of 2008, the lack of confidence reverberated around the globe as all types of risk were suddenly shunned. As has frequently been the case in these types of market dislocations, the global markets fared even worse than the U.S. markets. The S&P 500 fell 28.5% in the second half of 2008, while the Russell Developed Large Cap ex North America Index was down 36.9% and the Russell Emerging Markets Index was down 48.2% over the same six months, according to Standard & Poor's and Russell.

Particularly in the case of the emerging markets, the "flight to quality" appears to have been largely indiscriminate and may have created an opportunity for investors with a reasonable risk appetite.

Most economists agree that any recovery from the current recession in the U.S. and most of developed Europe is likely to be a slow one, one that may take several years to regain the 2007 levels. Real U.S. GDP growth has been negative for each of the last four quarters (through June 30, 2009), and fell at a 3.9% rate for the trailing 12 months, according to the Bureau of Economic Analysis.

Forecasts for 2010 generally fall in a 2% to 2.5% range, primarily supported by government spending rather than significant contribution from the private sector. On the other hand, forecasted growth rates for many of the emerging economies are much more robust. Merrill Lynch's most recent research report (dated July 8, 2009) is forecasting strong growth for China at 9.6%, India at 7.3% and Brazil at 4.5%.

These opportunities are supported by two main factors that have not generally been in place during past recoveries. First, the primary source of problems in the U.S. and European economies is embedded within the financial systems of these two regions. Specifically, the pricing bubble in real estate in both regions that was exacerbated by the profligate use of credit derivatives had little or no direct impact on the financial systems of the emerging countries. Secondly, at the outset of the financial crisis, many of the emerging economies were in much better fundamental shape than ever before. In fact, Brazilian government debt was rated as "investment grade" for the first time ever early in 2008. While the developed nations have been forced to bolster their individual economies through stimulus spending, many of the emerging economies have been able to avoid deficit spending and stimulated their economies through lowered interest rates alone.

Investors can gain access to the emerging markets through a number of different avenues. The traditional choice has been through mutual funds that specialize in either the equity or debt of these markets. However, many separately managed account (SMA) portfolios are increasing their emerging markets exposure using ADRs (American Depository Receipts). Thanks in part to an SEC rule change in late 2008, there have been more than 600 new ADRs created in less than a year, many from the leading companies in the emerging markets. This flood of new ADRs is giving portfolio managers a much broader reach and a much deeper pool of potential investments. The current universe of ADRs tends to represent the Latin American region exceptionally well, has good coverage over most of Asia, but is still somewhat limited in Eastern Europe and the Middle East. However, it may not be long before an all-ADR emerging markets portfolio will be available in a separately managed account.

Until then, however, the current mix of developed and emerging market ADR portfolios may be beneficial to the average investor in two ways. First, it allows the investor to get both international or global developed market exposure and emerging market exposure from the same manager, which allows for better risk management and lowered costs. Additionally, it puts the active decision for emerging markets exposure in the hands of presumably seasoned investment professionals who should be better able to judge the risk/reward profile of the emerging markets.

J. Gibson Watson III is president and CEO of Denver-based Prima Capital, which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.

Reprints Discuss this story
This is where the comments go.