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Even After a Huge Rally, Emerging Markets Still in Favor

Despite a stunning surge of nearly 50 percent that otherwise might indicate a looming pullback, investors remain mostly bullish on emerging markets.

Global Markets
CNBC.com
Global Markets

"It's a great story. It's our favorite story over the next 12 months," said Alec Young, international equity strategist with Standard & Poor's Equity Research. "Investors need to own this long-term."

Equity markets in the US and other countries have followed a similar pattern over the past year—a vicious bottom late last fall, a retest of the lows in March, followed by a violent spring rebound—but some analysts are expecting a decoupling of the two groups in coming months.

While U.S. economic growth is expected to be tepid at around 1 to 2 percent next year, global GDP is expected to rise 3.7 percent in 2010 with emerging markets forecast to gain 5.5 percent, according to research from Bank of America/Merrill Lynch Securities.

China and Brazil are two investor favorites from a group expected to benefit from gains on commodities, exports and a surge in financing activity that will drive prices for years to come. China's Shanghai index is up more than 75 percent this year, making it the global leader in equity markets; Brazil's market is second with 38 percent growth. MSCI's emerging stock index gained more than 2 percent Monday.

"Simply put, we think China's recovery is real, robust and sustainable," BofA/Merrill Lynch economist Ting Lu said in a recent research note.

Lu projects China's GDP gains in the 8 percent range for the rest of 2009, posing some challenges to regulators who nonetheless aren't likely to take any drastic measures to cool economic growth.

Brazil also has emerged as an investor favorite thanks to a changing, highly capitalistic business attitude.

For some, investing in the two nations, which make up the core of the so-called BRIC countries that also include Russia and India, is a natural play for investors wary of the weakening U.S. dollar. Brazil, in fact, joined Canada on Monday in dumping Treasurys because of fears over the dollar.

"If you play some funds in emerging markets, you're really diversifying out of the US dollar," said Tom Busby, president of the Diversified Trading Institute in Mobile, Ala.

Busby advocates using the WisdomTree Dreyfus Brazilian Real exchange-traded fund to capitalize on growth in Brazil. The fund, a lightly traded offering with about 68,000 shares moved each day, tracks money market and currency moves in Brazil.

Cooling Off

To be sure, there is some caution in the emerging markets trade.

Even someone as bullish as S&P's Young said he believes emerging markets will cool off following their springtime run and end up with returns that are considerably reduced from the current massive growth rates.

"It's going to be a two-steps-forward, one-step-back story," Young said. "Looking out 12 months, we do see better performance out of emerging markets, but people need to temper their expectations. We think this is more of a 10 percent gain. That's more upside than we see for the U.S. and Europe and Japan."

Investors looking to get into emerging markets can make plays through individual companies and commodities. But most investment professionals recommend either actively managed funds or the more accessible exchange-traded funds, which can be purchased and traded just like stocks.

"If you're in the right ballpark you might not get everything that's due you but you'll get the majority using exchange-traded funds," he said.

One of the more popular ETFs for emerging markets, with an average daily volume of more than 70 million shares, is the iShares Emerging Markets Index , which has gained 40 percent this year.

Even with the ETFs, investors who aren't careful can get hit.

Most advisors are recommending that investors allocate no more than 10 percent of their portfolios to emerging markets, and Young said S&P suggests no more than 5 to 8 percent of their entire equity portfolio.

Others are even more leery about going into emerging markets until a clearer picture emerges of the global economy.

"We're still cautious. We think the market got ahead of itself," said Wyatt Crumpler, vice president of asset management at American Beacon Advisors in Fort Worth, Texas. "In certain countries, there's a lot of political uncertainty. It kind of smells like where we were at about this time last year when it all collapsed."

Though Crumpler helps manage the American Beacon Emerging Markets Fund , he said the firm as a whole is advising only a 5 to 8 percent allocation toward emerging markets. The company manages the American Airlines pension fund.

"We still think that the real economy is suffering in the developing countries, and that is going to continue to have some impact on the emerging markets," Crumpler said.

Young said investors who use their heads should be able to get a nice benefit from the group through the next year.

"From their lows they're up a huge amount," he said. "We're just advocating caution at this point."

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