Emerging Markets: Less Volatile but Directionless

The Global ETF Profits Portfolios feature ample exposure to several key emerging markets. Now that we’ve reached the mid-point for 2011, it’s time to take a fresh look at these markets.  As you can see in the chart below, the MSCI Emerging Markets Index has traded in a relatively tight range this year. Meanwhile, the index’s volatility has been manageable.

However, the first quarter’s 10-plus percent rally evaporated by the end of June. This performance means that a buy-and-hold strategy hasn’t rewarded investors this year. By the same token, excessive trading hasn’t profited investors enough to justify the cost.  

Source: Bloomberg

Investors have been beset by a number of potent risks to the global economy, including the sluggish pace of the US economic recovery, the EU sovereign debt crisis, rising inflation in China and the possibility of a hard landing for that country’s economy. These are serious issues that will dominate the debate among investors throughout 2011. Consequently, this is a suitable moment to re-examine the investment case for emerging markets.

In the narrow sense, the selloff in emerging-market stocks has pushed valuations to attractive levels; short-term headwinds notwithstanding, investors have been presented with favorable entry points for emerging markets this year. The MSCI Emerging Markets index currently trades at about 10.4 times forward earnings, well below the long-term average of 11.5, and certainly much lower than the valuations typically found in these markets during periods of strong growth. If these markets improve only slightly during the rest of the year, bringing valuations on par with the long-term average, we’ll see a strong performance of about 20 percent by year end.

Asia is our favorite region among the emerging markets and we expect the region will lead any emerging-markets rally this year. Asia epitomizes the promise of emerging markets. The region boasts strong gross domestic product (GDP) growth, solid earnings-per-share (EPS) growth, low cost of capital, below-average valuations and strong underlying fundamentals. Asian markets trade at 2.0 times price-to-book value, within the historical range of 1 to 3 times price-to-book value. That’s an undemanding valuation given that Asian corporations are expected to post strong profit growth this year amid robust economic growth in regional economies.

We believe the global economy will not slip back into recession. Consequently, the current weakness is an opportunity to allocate funds toward emerging markets. This can be done by establishing a position, or building upon an existing position, in iShares MSCI BRIC Index Fund (NYSE: BKF). Investors can also consult our Portfolio pages for sector- and country-specific recommendations.  

Asia will outperform this year and for the foreseeable future. The region’s economic fundamentals are far more favorable compared to other emerging-market regions and developed economies.

On a company level, a fresh capital expenditure cycle is underway in Asia, which will boost earnings next year as well. This process has also yet to be factored into today’s prices. Asian companies are investing in their businesses because they have clean balance sheets and are faced with strong demand. Clean balance sheets are critical for all investors that commit capital to Asia; it’s the only region where corporations are fiscally strong and the domestic economies offer robust and sustained growth.

China remains our favorite market in Asia and it currently trades at a discount to its historical price-to-earnings ratio. We believe that inflation in China will peak soon, the government’s monetary policy tightening program will likely end, and the economy will achieve a soft landing. Market Vectors China ETF (NYSE: PEK) offers pure exposure to China and is the best way to profit from these trends.

The summer of 2011 will be a sequel of 2010–a weak but gradually rising market will culminate in a fourth-quarter rally. The pieces are slowly falling into place for strong markets later this year.

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