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

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

Korea

Korea has a new, more pro-business President, Lee Myung-bak., who ran on a pro-growth platform of cutting both taxes and regulations. However, there are a number of economic concerns that are affecting investor sentiment. Domestic demand growth in Korea looks likely to be weaker than in other emerging market economies. Korean banks have experienced serious funding problems and interest rates have risen sharply. These high rates will hurt the heavily indebted Korean households. This does not bode well for Korean equities in the coming months. Later in the year the fiscal stimulus and market-friendly reforms planned by the new government should be important positive factors for equities. The Korean stock market as measured by the MSCI Korea Index registered a strong increase of 30% in 2007 but has underperformed in recent months.

Brazil

Outside of Asia, Brazil is the other major center of growth among the emerging markets. Indeed, in 2007 Brazil’s equity market registered the strongest performance among the major emerging markets. The MSCI Brazil Index rose by 75.4% last year. India came in second with a 71.2% increase. It is noteworthy that this outperformance by Brazil continued through the recent adjustment in global markets.

Brazil’s economic prospects continue to look benign, with growth in excess of 4% expected in 2008. While Brazil is affected by developments in the global economy, it is not as directly tied to the US economy as are other Latin American countries, for example, Mexico. This currently is a plus as the US economy passes through a slow growth period. Another significant plus is the growing importance of Brazil’s energy sector. Despite the fact that Brazilian equity valuations are no longer cheap, this market is expected to perform strongly again in 2008.

Mexico

In contrast to Brazil, Mexico has limited ability to insulate itself from developments in the US. The housing slump and the credit crunch in the US have had a depressing effect on Mexican equities, which declined during the latter half of 2007. As a result, the MSCI Mexico Index advanced by only 9.3% in 2007, in sharp contrast to the Brazilian market. Mexico’s interest rates remain very high, and its equity valuations are not particularly attractive. This situation may turn around later in 2008 when monetary policy is expected to ease and it becomes evident that the US has avoided a serious recession

Postscript

in recent days, there have been violent riots in Pakistan, following the tragic assassination of Benazir Bhutto. The global struggle against terrorism has become more difficult with this testing of Pakistan’s political stability. While there has been little effect on global equity markets or on spreads on Asian emerging market sovereign bonds, this event was a reminder to investors that we live in an uncertain world. Investing in emerging markets, despite the many advances that have been achieved, still involves a higher element of risk than is the case for the advanced market economies with their deeper, more liquid markets, stronger regulatory and legal systems, better corporate governance and more stable political structures.

Their generally higher risk does not mean that emerging market equities should be avoided. Rather, it underlines the importance of diversification of risks as an essential element of prudent portfolio management. A distinguishing feature of risk management at Cumberland Advisors is our exclusive use of Exchange Traded Funds in our managed equity portfolios. These securities, which are traded like single stocks, provide broadly diversified investments at relatively low cost in entire country markets, regions, sectors and/or investment styles. For example, the iShares Korean ETF (ticker EWY) holds the shares of some 100 Korean companies. One of our core ETF holdings, the broad BLDRS Emerging Markets 50 ADR Index Fund (ticker ADRE) invests in 50 companies in eleven major emerging markets. A high level of diversification can be achieved through building portfolios with such funds.

The index returns in this article are US dollar returns and therefore are heavily affected by the depreciation of this currency in 2007. For example, The Canadian dollar MSCI Canada Index return for 2007 was only 8.2%

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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.
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