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It seems that every product on the shelves of our stores is now manufactured in emerging markets such as China. This phenomenon has also been accompanied by a substantial increase in the availability of emerging market investments. Substantial press coverage has been dedicated to investing in emerging markets as of late, but should these investments play a role in a “back to basics” portfolio?
The Urge to Emerge:
So, just what is an emerging market? As defined by the World Bank, an emerging market is an economy with low to middle per capita income which has embarked on economic development and reform programs designed to open up their markets and “emerge” onto the global economic scene. Key elements in these reforms include transparency and efficiency in capital markets and exchange rate reforms designed to stabilize currency. Current emerging market countries include nations such as China, India, Mexico, Argentina, Brazil, Venezuela and the Russian Federation.
No doubt the World Bank definition above is completely understandable to everyone – that is everyone with an economic degree! The use of an example may better illustrate an emerging market, and no better example exists than the recent development in China.
Red Dragon:
In 1989, after years of oppression at the hands of the communist government in China, a group of Chinese students and intellectuals lead a peaceful protest against the country’s leadership in Beijing’s Tiananmen Square. No one who witnessed the events will ever forget the images of a lone Chinese student defiantly blocking a row of tanks sent by the government to end the protest. Unfortunately, this act of courage only temporarily halted the military’s advance and many protestors lost their lives as the government forcibly disbanded the protest.
The events of Tiananmen Square stand in sharp contrast to China today and illustrate the country’s development into an emerging market power. Less than ten years after the deaths in Tiananmen Square, the regime responsible for the Tiananmen incident was gone, and a new Premier, Zhu Rongji, was appointed with a policy of economic reform and development. The sweeping reforms included greater information and access to Chinese capital markets, heightened Chinese adherence to world economic accountability standards, and currency reform tying the value of the Chinese Yuan to the U.S. Dollar.
These reforms prompted the United States to grant China normal trade relations in the year 2000 and by 2001 China had entered the World Trade Organization. Today, only seventeen years after the Tiananmen incident, China is a globally recognized economic power, and serves as an excellent illustration of an emerging market.
Emerging Returns:
The recent performance of emerging market equities highlights the potential power of these investments. As measured by the iShares MSCI Emerging Markets Index Fund, emerging market stocks achieved a total return of 185.61% since April of 2003. This translates into an annualized total return of 36.46% over that period of time. In contrast, the S&P 500 Index realized a total return of 54% since April of 2003, with an annualized total return of 11.64%.
In addition to stellar performance, the opportunity in emerging markets seems unlimited. According to the World Bank, developing economies constitute 80% of the world’s population but only 12% of the world’s stock market capitalization. The International Monetary Fund estimates that between 50% and 70% of the world’s incremental economic growth could occur in emerging economies over the next decade.
Clearly, emerging market investments offer incredible return potential and opportunity, but what are the risks?
Emerging Risks:
The opportunity for high emerging market investment returns comes with the potential for increased volatility and risk. In a recent one month period spanning May to June of 2006, the iShares MSCI Emerging Markets Index Fund declined by 21%, wiping out the gains of many investors who were late jumping on the emerging market bandwagon.
In addition, emerging market countries have greater potential for political instability such as revolution or civil war, which can quickly derail economic development and investor returns.
Emerging Markets Now:
Given the opportunities and risks, should emerging market investments be part of a “back to basics” investment portfolio?
Clearly the potential opportunities in emerging markets make these investments essential for inclusion in most equity portfolios. Our firm, Private Wealth Advisors, continues to include these investments in our equity allocation. However, the outstanding performance of these investments in the last few years has made valuations less attractive prompting us to reduce our client’s exposure and take profits from this sector. In addition, we are exploring investment in more established companies such as Caterpillar or Coca Cola which should benefit from sales to emerging market countries for the development of infrastructure and to supply the growing consumer base.
Emerging market investments can play a key role in the growth of a long-term equity portfolio. However, given the inherent risks of this investment class, investors should use emerging market investments in moderation and be prepared for a potentially bumpy ride.
Sources: Baseline, Morningstar, World Bank, International Monetary Fund
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