Investors hurt by last year’s market turmoil have enjoyed an encouraging turnaround, with many of the worst performing asset classes from 2011 having pivoted to become the standout performers of the new year. Such has been the case with emerging markets.
Many investors are probably wondering how much further these markets will climb in 2012. There are fundamental underpinnings for the current rally in emerging markets, and many secular factors that support a continued rise longer-term.
Emerging markets suffered badly last year due to a confluence of factors. In the first part of the year, inflation had surged in many developing countries, primarily sparked by rising commodity prices. A number of central banks (most significantly China’s) were in the process of raising interest rates in an effort to combat high inflation.
By the third quarter, market participants were consumed with the European debt crisis, and sentiment shifted dramatically toward risk aversion. The dollar strengthened dramatically versus most emerging market currencies, only heightening volatility and contributing to a further downward spiral.
> BRIC Map
The environment has improved markedly over the past few months. Monetary tightening cycles have given way to easing in many developing countries, and their currencies have strengthened against the U.S. dollar.
The Euro-zone crisis still commands big headlines and the rating agencies continue to consider downgrades of the region’s sovereign debt. By contrast, debt ratings in emerging markets have been trending higher, in some cases commanding upgrades to investment grade status, due to a lower debt burden and sufficient reserves.
Looking longer-term, the broad emerging markets story is supported by a number of promising secular trends that will serve as growth drivers. The BRIC countries (Brazil, Russia, India, and China) boast favorable demographics. A growing middle class with a rising level of disposable income, coupled with rapid urbanization will spark major investments in infrastructure and will continue to grow the real estate and construction industries.
Given the global backdrop of slow growth and low interest rates in the developed economies, as well as the transmission mechanism from the developed world to the emerging world by way of trade and financial flows, we believe investors in emerging market bonds and stocks will continue to be rewarded.
The equity universe in emerging markets has broadened considerably over time. From its beginnings as a small asset class consisting of mostly financial services and utility companies, it has grown into a diversified list of world class companies.
Even with significant investor inflows over the past decade, the emerging market segment appears vastly underrepresented, with total investment in emerging market debt and equity securities less than 10% of global portfolio assets. The emerging markets share of world GDP, however, is poised to surpass the collective GDP from developed nations.
David Kudla is CEO and Chief Investment Strategist of Mainstay Capital Management, a fee-only, independent, Registered Investment Advisor.