Rachel Koning Beals

Recent declines in emerging markets have spooked investors, but the long-term outlook remains favorable

Although emerging markets have taken a dive lately, the long-term outlook for these fast-growing countries remains favorable for investors, especially as growth in much of the developed world stalls. Investors should consider folding high-growth global exposure into a balanced portfolio.

Declining prices of emerging market stocks have clearly spooked some investors. In one example, South Korea's leading index, the Kospi, suffered one-day losses in early September of 6 percent, a drop that hadn't been seen since the 2008 global credit crisis.

"Decelerating growth, high inflation, and the implementation of tightening policies in some emerging markets also resulted in investors' nervousness," said Mark Mobius, executive chairman of Templeton Emerging Markets, part of Franklin Templeton Investments, in an August research note.

Last year, U.S. mutual-fund investors pumped nearly $96 billion into emerging-market funds, according to EPFR Global. Through July of this year, U.S. investors had pulled $12 billion from the fund category.

As some investors rush the exits, those with a longer horizon may find the category's cheaper point of entry attractive. The MSCI Emerging Markets Index is trading at around 10 times 2012 analyst estimates, compared with a historical average of 11.5.

But price isn't everything. First, there is a positive fundamental backdrop to investing in emerging markets. In Asia, for example, the deleveraging house-cleaning seen after the region's late-1990s financial meltdown has led to healthier government and corporate balance sheets today. Much of the region now has large surpluses and hefty fiscal reserves because many Asian countries have become greater producers of goods, less reliant on imports, and citizens are bigger savers than spenders. This improves the credit ratings of governments and companies.

Middle class emerges.Clearly, there are bullish reasons to consider investing in emerging markets as a sector. Or, in the case of the Alpine Emerging Markets Real Estate Equity Fund (symbol AEMEX), investors might consider a particular economic area believed to be ripe for growth: housing and commercial property development and sales. The fund, which gives some 35 percent of holdings to Brazil's real estate-linked stocks, is up 21.9 percent over one year.

"Real estate provides a dynamic way to participate in structural long-term growth," says Joel Wells, a co-manager for the fund, which combs 1,000-plus companies in 45 countries for investing opportunities. "Because developed-market consumption has been stimulus-driven, it is not sustainable. There is a growing emerging market consumer glut due to a younger population, as more enter the workforce, and because of lower debt, presenting a much more stable platform. In Indonesia, for example, 60 percent of the population is below age 30."

Make no mistake that the health of emerging economies is intertwined with the economic strength of the developed nations that snatch up their products. Areas that make cars and technology, like South Korea, Taiwan and China, in particular, would be hurt if the United States slides back into recession or lingers just above recessionary levels, as more economists are predicting.

Economic growth in the Group of Seven largest economies excluding Japan will grow at an annualized rate of less than 1 percent in the second half of 2011, the Organization for Economic Cooperation and Development said in early September, a downgrade from its previous view. The International Monetary Fund is predicting emerging market growth closer to 6 percent.

"Growth is turning out to be much slower than we thought three months ago, and the risk of hitting patches of negative growth going forward has gone up," OECD Chief Economist Pier Carlo Padoan said during a presentation of the OECD's Interim Economic Assessment.

Global ripples.

"Economic giants like China and India, with their increasing demand for commodities and natural resources, play a pivotal role for growth in the region. In Southeast Asia, countries like Thailand and Indonesia have seen very rapid growth in the last decade, and frontier markets like Vietnam and Laos, with their strong growth potential, are also very interesting to us," says Templeton's Mobius. "We are very interested in Indonesia, a large country with increasing per capita income. We have also seen a continuing evolution toward broader and deeper capital markets in Thailand."

South Korea is dependent on foreign trade with established economies and growing emerging markets such as China; emerging-market partners buy 70 percent of Korea's exports.

"We see inflation, especially rising food prices, and higher interest rates as a few key risks to growth in Asia today," Mobius said. There are inflation risks in Brazil, China, and India, in particular, where prospects for higher interest rates to combat inflation remain. Brazil is expected to grow 4 percent this year. China's economy is advancing at a 9 percent clip, and India is growing at 7 percent.

But inflation, too, should be held back by slower global growth, says Wells. Important for investors is the fact that emerging-market central banks have some wiggle room with interest rates.


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