But some experts worry emerging markets are overheating.
By Alan Lavine
The declining value of the dollar and a strong global economy bodes
well for foreign stocks, despite a decade of underperformance in the
1990s.
A recent survey of investment managers by the Russell Investment Group,
Tacoma, Wash., found 54% optimistic and 17% pessimistic. The rest were
neutral. But some leading international investors see the growing
interest and optimism surrounding this asset class as a potential
harbinger of self-fulfilling problems and excessive valuations.
Meanwhile the World Bank recently forecast economic growth ranging from
about 4% to almost 8% in 2006 and 2007 in developing countries and 1%
to 3.6% in the United States, Japan and Euro Area countries (See table).
Although money managers have high expectations, it's not a cakewalk.
Emerging markets are extremely overvalued and due for a pullback,
believes Jeremy Grantham, chief strategist and chairman of Grantham,
Mayo and Van Otterloo, Boston.
In China, the greatest risk may be optimism based on country's strong economic growth. Investors overlook the risk that labor unrest poses to the country's capital markets. For example, 80,000 petroleum workers in northeast China protested wages and working conditions in 2002. Meanwhile, stocks in the China region experienced double-digit losses.
Kate Weingart, author of Working in China (AuthorHouse), says the
country's labor problems are similar to those the United States
experienced in the early 20th century. There have been large numbers of
strikes involving thousands of people over the past few years. The
reasons include: Wage inequality between rural and urban workers;
benefit inequality between government and private business workers; and
poor working conditions for unskilled laborers.
"The labor problems are a risk to the financial system and the
markets," says Weingart, professor of organizational leadership at
Purdue University.
Another potential problem cited by analysts: Economic problems in the
United States could impact the rest of the world, particularly
exporting countries like China. Grantham says the real risks to the
world financial markets are geopolitical or some type of crisis-not
economic.
"The biggest risk over the next couple of years is if something bad
unexpectedly happens to the United States," he says. "It echoes around
the world. It is not the economy, but a couple of random things that
could go wrong. Then you could see a quarter with 20% losses in the
foreign markets."
Such risks help explain why correlations between international stocks
and the United States under normal conditions are 70%, and as high as
90% in down markets.
Foreign stocks exhibit greater volatility in their
correlations with U.S. stocks than they have in the past, indicates a
working paper by Andrew Ang and Geert Bekaert, Columbia University
finance professors. The paper, International Asset Allocation with
Regime Shifts, found correlations between international stock returns
and U.S. stock returns tend to increase in highly volatile bear
markets. So investors must monitor the correlations and make the
appropriate adjustments in their asset allocation mixes.
Despite the risks, money managers say there are a lot of investment
opportunities. The most attractive areas are China and other emerging
markets. The Chinese economy is expected to grow at 8% to 9% over the
next year.
Meanwhile in Asia, excluding, China, low real rates, and improved
banking systems should help boost consumption. Strong exports to China
and Japan should support economic growth.
The outlook in Europe, however, is less exciting. Gross Domestic
Product (GDP) is expected to grow just over 1% in countries that make
up the euro zone. But restrained European wages should help profit
growth.
Thomas Melendez, manager of the MFS International Diversification Fund,
says that emerging markets are the best place to invest. He recommends
that investors keep about 5% to 8% of their portfolios in emerging
market stocks.
Nevertheless, he says that it's best to diversify
internationally due to high risks in thinly traded markets.
It's evident that many of the structural reforms enacted during the
late 1990s and early 2000s in emerging markets have set the stage for
growth in these economies, he says. "Corporate reforms that have taken
place on a company-by-company basis have resulted in an unprecedented
strength of their balance sheets."
Another positive factor: Interest rates and inflation have declined
significantly, allowing for sustainable growth in these economies as
well as in many companies.Over the next 30 years, Melendez says, the
economy of India is expected to overtake Germany, the third-largest
economy in the world. By the middle of this century, the economies will
have very technical skilled labor forces.
"Emerging markets are trading at a 25% discount relative to the U.S.
market," Melendez says. "Many of the emerging market countries have
investment-grade ratings by Standard & Poor's. This is a sign of
financial health."
Some of the largest holdings in MFS' International Diversification Fund emerging market sector include:
Samsung Electronics, one of the fund's largest emerging market
holdings. It sells at just ten times earnings, but future earnings are
growing 16% annually. The company is profiting from flash memory cards
used in iPods and other electronics.
Companhia Vale do Rio Doce, a Brazilian iron ore mining company. This
company has been raising prices at dramatic rates due to strong demand
for ore from Asia. Earnings are growing at double-digit rates.
Tebaris, a Latin American company that makes seamless steel pipes for
oil exploration. The company's revenues and profits are rising due to
the strong demand for products by the oil exploration industry.
Edmund Harris, manager of the Guinness Atkinson Asia Focus Fund, says
he's finding the best investment opportunities in China. "In the
past it's been an export story," he says. "But now it's a consumption
story. There are growing investments in China and the domestic economy
is reaccelerating. There is growth in Chinese companies involved in
infrastructure, electric production and coal mining."