From the July 2010 issue of Research Magazine • Subscribe!

Will Emerging Markets Soar?

Richard Kang looks hard at emerging markets.

Emerging markets have thrived recently, rising around 75 percent in the past year alone. Is this a multi-year mega-trend or a flash in the pan? In the face of Europe's financial crisis, can emerging markets repeat their past success?

To find out, Research asked Richard C. Kang, chief investment officer and director of research at Emerging Global Advisors (EGA). At the end of April, EGA managed $114 million in six sector and country-focused emerging markets ETFs. Kang shares his insight and views about what lies ahead for this exciting asset class.

Your company recently launched infrastructure ETFs that follow stocks in China (CHXX) and Brazil (BRXX). Tell us more about the infrastructure opportunity.

The key factors underlying the emerging market story as it relates to infrastructure are population, urbanization, economic transition and wealth accumulation.

Any emerging market of the past that has risen to "developed" status has transitioned to one based on resources (mining/oil dependency, agriculture) to one of manufacturing and potentially diverse services. This transition includes an often massive urbanization trend. Government control of this transition is key as some cases have been managed poorly while some with better results. After the KoreanWar, Seoul transformed [from] a city of less than a million to now at well over 10 million or roughly a quarter of the country's population.

This is a good example of large scale transition. Many cities in Japan and Western Europe are equally valid as examples.

For other cases of urbanization, the result has been poor. Mexico City would be an example. The difference is government planning and their steadfast intent to focus on the longer term objective of progress and modernization. Today, based on the first factor of demographics, we find that the key opportunities are in China, Brazil and India. In these countries, although to varying degrees, we see that their governments are spending (and have already spent) significant monies to fund major infrastructure projects. We know what their airports will look like. We can already see it in Seoul, Hong Kong and Singapore. It's simply a matter of time.

It's key for investors to understand that we're witnessing the greatest move of people out of poverty in the history of this planet. That's not an exaggeration. It is simply a matter of a high population never seen before in history and the major advances in technology that allow for a modern economy to be built based on certain prerequisites (healthy, educated population; access to commodities and data; good supply of water and food; etc.). But it's not enough that they're making money. We also have a pendulum swinging from developed markets to emerging markets. Due to past excess, we in the West are forced in aggregate to save more and spend less. In the developing world, they have the freedom to save less than they have historically, thus allowing for more spending.

Over the past year, gold has underperformed metals and mining stocks (EMT). What's your view of gold?

Gold has surprised many by its relatively poor performance. Still, it has recently hit roughly $1,210, a rise of over 13 percent since a bottom in early February. This recent high is close to the highs of early December, which on a nominal basis is the major secular high of this recent bull market. The fact is that so many investors focus on gold's role as a quasi-currency, an inflation hedge or other financial role.

As with any commodity, the forces of supply and demand rule. This means that Indian demand during their traditional wedding season matters. It also means the surging industrial demand from emerging markets that has slowed along with the rest of the world post-crisis also matters.

Clearly, demand for the PGM [platinum group metals] has been a bigger story. Also key is the importance of investors thinking both of commodity prices as well as the companies that mine these resources. Given the need for diversification and the positive outlook of emerging market economies, it's little surprise that there has been so much attention to mining companies. The focus has been widespread including names from Brazil (Gerdau, Vale), South Africa (AngloPlatinum) and China (Jiangxi Copper), among others.

Many emerging markets countries are heavily dependent on rising commodities prices. Do you think emerging markets can still do well, even if commodities prices do nothing?

Many emerging markets are dependent on commodity prices but going forward they will be even more dependent on broad-based domestic consumption. By broad-based I mean beyond corporations and governments but households as well. This is a key transition period where we will witness the growing importance of the new middle class consumer/investor in emerging markets.

Forward looking, investors realize that they cannot be dependent on Western consumers who need to deliver and clean up their balance sheets. This means less spending and more saving. The opposite is true in the developing world. Although individually their wallets may be small, in aggregate they are a force to be reckoned with. In aggregate, they will be incentivized to spend just a little bit more and save a little bit less. Witness how much of the S&P 500 constituents top line revenue is derived from foreign sales, and in particular, emerging markets and one realizes the importance of accessing these markets. For various political reasons, it's clear that competing in these markets will be tough as the system will allow for governments to play favorites for local businesses.

What type of impact do you think BP's massive oil spill in the Gulf of Mexico will have on the energy sector?

This is another catalyst for what will likely be government attention to profits from domestic oil companies. The U.S. government and European governments cannot continue to rely on financing from China and others. With a low-growth environment and no wage inflation, taxation of households is difficult to implement. A VAT tax will only stifle growth but seems to be a needed tool to bring in more revenues. Of course, the easy tax is to hit the oil companies as well as mining companies and exporters in general who are raking in decent profits. This strategy fits the populist agenda although its effect overall on budget finances may be minimal. Still, a windfalls profit tax to oil companies was promised by Democratic presidential candidates so rising oil prices only make their case stronger. This oil spill in the gulf provides added incentive.

Heavy debt loads have weighed on large European governments, but stocks within some of the euro's emerging countries like the Czech Republic, Hungary and Poland have held up better than developed European countries. How do you explain this?

There is capital market decoupling observed today even though broad economic/trade decoupling has not happened. Quite simply, the outlook of Western Europe looks bleak. The markets were up strong on Monday May 10th after news of a nearly $1 trillion package essentially built by the European Union and the IMF to bail out Greece.

One must ask [if] the intent to provide short-term stability is worth the rather self-defeating incentives being set out for the longer term. The European Union was never designed to be an insurance policy for weak economic [states] because that's the role of the IMF. Given that this economic recovery from a harsher than normal recession is slow, spreading the burden from the PIIGS to other European nations is questionable.

Derivatives have recently come under fire by the Securities and Exchange Commission. Do you think the SEC has overreacted and do any of EG shares use derivatives?

The SEC's job is to protect investors, sometimes from themselves. Many ETFs including ours do not rely on the use of derivatives to gain exposure to the underlying securities which constitute the index portfolio. However, for a good proportion of relatively new products, derivatives use is key. Derivatives in ETFs including ETNs have a worthy role. They allow for extremely precise tracking of the underlying index. They can actually make the management of the fund easier in an operational sense. However, there is a degree of counterparty risk that can't be hedged. Furthermore, product complexity in ETF-land almost always gets even more complicated through the use of derivatives. In this case, I am focusing on the misunderstanding of levered ETFs.

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