Advisers plan to go on an emerging-markets shopping spree this year — and experts say the timing couldn't be better.
A majority of advisers — 51.4% — plan to increase their clients' allocation to emerging-markets equity this year, according to the InvestmentNews 2013 Investment Outlook survey, in which 592 financial advisers participated. At the same time, 32.8% plan to increase allocations to emerging-markets fixed income.
It turns out there's quite a lot to be bullish about with emerging markets this year, even though equities in this category have underperformed their developed counterparts in the past. The MSCI Emerging Markets Index, for example, lost 18% in 2011 but gained 19.1% in 2012. Meanwhile the S&P 500 rose 2% in 2011 and had a total return of 16% last year.
For starters, the historical underperformance has left emerging markets trading at a discount to developed economies. The aforementioned MSCI index is trading at about 11 times future earnings, while the MSCI All Country World Index is trading at nearly 14 times forward earnings.
That's about a 25% discount, which usually signals good things for emerging markets, said Russ Koesterich, chief investment strategist at BlackRock Inc.
“If you can buy emerging markets at 75 cents on the dollar, compared to developed markets, that's historically a good entry point,” he said.
In addition to the attractive valuations, there's also a good chance that emerging markets can grow at a faster pace this year, Mr. Koesterich said.
“We think emerging markets have hit an inflection point,” he said. “A lot of the large emerging markets disappointed on the growth side in 2012. We do think these countries will grow faster in 2013.”
The biggest drag on growth in 2012 was the carryover effect of fiscal tightening in 2011 to fight inflation. With inflation no longer a concern, the two biggest emerging markets, China and Brazil, have begun to ease monetary policies, Mr. Koesterich said.
China is the country that will be the most watched this year. It makes up about 17% of the MSCI Emerging Markets Index, and investors' perception of China plays a significant role in how they view emerging markets in general, Mr. Koesterich said.
Two-thirds of global portfolio managers expect China's growth to accelerate this year, according to the December Bank of America Merrill Lynch Emerging Markets and Asia Fund Manager survey. It's the highest incidence of bullishness about China the survey has ever recorded.
“As emerging markets have grown, so has the opportunity in small-caps,” said Dave Mazza, head of ETF investment strategy at State Street Global Advisors.
Conrad A. Saldanha, portfolio manager of the $215 million Neuberger Berman Emerging Markets Equity Fund (NEMAX), has one-third of his portfolio invested in mid- and small-cap companies.
A lot of the larger companies found in emerging markets are global conglomerates, which are more likely to be affected by swings in the global economy. The smaller companies are more likely to derive the majority of their revenue from inside the country, Mr. Saldanha said.
But he warns of circumstances outside corporations' control: “There's still the external risk of the eurozone.”
If the sovereign-debt crisis in Europe heats up again this year, it could lead to investors' selling off risk assets, such as emerging markets, thereby dragging down returns.
STRONG BALANCE SHEETS
Ironically, sovereign debt is one area where the emerging markets are far outpacing their developed counterparts.
Most of the developed world is still working through the excessive debt problems that spurred the Great Recession. Emerging markets, however, have much stronger balance sheets.
The average debt-to-gross domestic product ratio in the emerging markets is around 35%, while those in developed countries are hovering around 100%. That relative strength, along with higher yields, has led to a bull rush into emerging- markets-bond funds. The funds had a record $19 billion of inflows last year through November, up from $12 billion in all of 2011, $13.4 billion in 2010 and just $2 billion in 2009, according to Morningstar Inc.
And their performance hasn't disappointed. The average emerging-markets bond fund returned 17.8% in 2012, making it the top-performing fixed-income asset class last year. It has a five-year annualized return of 9.2%, making it the second-best-performing bond category over that time, edged out only by long government bond funds with a five-year annualized return of 10.4%.
Even with the surge in popularity, there's still room for advisers to increase their allocations to emerging-markets debt. The average investor has around 3% to 5% of his or her fixed-income portfolio allocated to emerging markets, even though such debt makes up about 10% of the global bond market, according to TCW Group Inc.
And emerging-markets debt issued in the local currency is a way for advisers to diversify away from the dollar, Mr. Koesterich said.
“There's some long-term appreciation opportunities versus the dollar,” he said.
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