Investing in Emerging Markets- Will the Boom Continue in 2008?

Author: Bill Witherell, Post Date: January 7, 2008

2007 was the fifth consecutive year that emerging market stocks registered a double–digit advance. They significantly outperformed US and other advanced markets. The broad MSCI (Morgan Stanley Capital International) Emerging Markets Index increased by 36.5%. This compares with an advance of 10.6% for the MSCI Europe Index and is almost 9 times the 4.1% advance in the MSCI US Index. (The MSCI Canada Index, however, was up by a strong 27.6% at year end).

Like last year, the same basic question applies, looking forward to 2008: “Will the boom continue?” Our response is conditionally “Yes”. The reason is that, as a group, emerging markets have become more mature. So far, they have demonstrated an impressive ability to weather the storms caused by the same credit crunch that adversely affected most advanced country’s markets in recent months. However, market volatility has increased, and country allocation within the emerging market universe is likely to be critical for portfolio performance.

The increased liquidity that major central banks are injecting into the global economy should help ensure that the current slowdown in the advanced economies is relatively short-lived. Cumberland does not believe it will deteriorate into a serious or global recession. Domestic liquidity conditions in most emerging market economies are healthy. Many emerging market countries are net creditors in the global markets. For them, domestic demand factors should underpin another year of solid economic growth.

While the large price advances in many of the major emerging markets in the first ten months of this year had reduced the relative attractiveness of their valuations, the market drawbacks in the last few months have tempered their overheated nature. China and Hong Kong are examples.

China and Hong Kong

The Chinese economy continued to grow at a very rapid pace in 2007, 11% according to some preliminary estimates. Domestic Chinese investors piled into the stocks of Chinese firms. Prices in the Shanghai and Shenzhen markets rose to speculative bubble levels by mid-year (Shanghai was up by 85%), followed by a retrenchment of almost 20% in the second half.

The domestic Mainland Chinese markets are largely closed to foreign investors. However, many of the major Chinese firms are listed on the Hong Kong market (via Chinese H shares) and/or the US market. These firms are required meet the higher reporting standards of these exchanges. There are several Exchange-Traded Funds trading in the US market that invest in these shares. The most popular of these, the iShares FTSE/Xinhua China Index Fund (ticker FXI), which tracks the corresponding index, advanced by 58.7% last year.

The pace of economic activity in China, while decelerating, is still likely to be again in excess of 10% in 2008. Domestic Chinese investors, with growing incomes, are still largely a captive audience. They will persist in flocking to China’s equity markets.

That said, Chinese equities may encounter some headwinds in 2008. A more rapid appreciation of the Chinese currency, the Yuan, perhaps as much as 10% over the year, is likely as the authorities seek to reduce inflationary pressures. This will hurt the earnings of Chinese exporters as well as the translation of equity returns into US dollars for US dollar-based investors. Another important risk facing Chinese exporters is the US Presidential elections and the effect that will have on US-China trade relations. Also the plans of Chinese companies to raise another $100 billion on domestic and international equity markets next year could weigh on those markets.

On the positive side of the ledger, the Chinese authorities will likely take further measured steps in the coming months to lower the present regulatory barriers preventing most domestic Chinese citizens from investing in the Hong Kong and US markets. The Hong-Kong and US-listed shares of Chinese companies are now priced at a discount of 60% or more relative to the prices of the shares of the same companies in the China Mainland markets. The expected process of arbitrage between the markets as the so-called “through train to Hong Kong” gets underway in earnest should give a significant boost to these shares over the course of the year.

Increasing the ability of Mainland Chinese investors to invest in the Hong Kong market should also attract substantial new funds into the securities of domestic Hong Kong companies. Anticipation of this development already added to the Hong Kong market’s performance in 2007. This factor and the close relationship between the Hong Kong and Chinese economies helped Hong Kong stocks, as measured by the MSCI Hong Kong Index, advance by 34% this past year. The leading domestic Hong Kong companies are in the real estate and financial sectors. Both of these sectors are helped by the prevailing low interest rates, an ample supply of liquidity, and strong fundamentals for the economy.

cumber map
Cumberland Advisors® is registered with the SEC under the Investment Advisers Act of 1940. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. Such an offer can only be made in the states where Cumberland Advisors is either registered or is a Notice Filer or where an exemption from such registration or filing is available. New accounts will not be accepted unless and until all local regulations have been satisfied. This presentation does not purport to be a complete description of our performance or investment services. Please feel free to forward our commentaries (with proper attribution) to others who may be interested. It is not our intention to state or imply in any manner that past results and profitability is an indication of future performance. All material presented is compiled from sources believed to be reliable. However, accuracy cannot be guaranteed.