Emerging-Market Stocks Are Set to Boom

by Daniel Putnam | September 14, 2012 12:31 pm

The term “central bank put” is now an anachronism. Puts, after all, have an expiration date. Quantitative easing[1], on the other hand, is now scheduled to last indefinitely.

Coming on the heels of China’s $158 billion infrastructure plan[2] and ECB President Mario Draghi’s July promise that he would do “whatever it takes” to save the euro, the message is clear: The powers that be aren’t going to let the markets fall.

The question is how to take advantage of this unique situation. Most higher-risk asset classes already have generated outstanding returns in the past few years, and the U.S. market is at multi-year highs. The same can’t be said for emerging-market stocks, however.

Click to Enlarge While the asset class has rallied nicely in the past three-plus months — with the Vanguard MSCI Emerging Markets ETF (NYSE:VWO[3]) rising 12.3% since the end of May — it still is far behind the developed markets in the past two years. Since Sept. 13, 2010, the SPDR S&P 500 ETF (NYSE:SPY[4]) has gained 35.56%, while VWO isn’t even in the neighborhood at a return of just 1.43%.

Why should the emerging markets start moving now?

The most important reason is that until the past few years, the emerging markets were historically the destination for excess liquidity in the financial system. When the central banks pumped and the developed economies weren’t yet strong enough to absorb the excess cash, the liquidity would flow into the financial markets in general, and the emerging markets in particular. However, concerns about China’s economic health have caused emerging equities to be left behind during the recent round of stimulus of the past few years.

That’s where the infrastructure plan comes in: Since the Chinese government announced the program last week, the various market segments that have been under pressure from China’s murky economic outlook have rocketed higher. From the Sept. 5 close through the first hour of trading Friday morning, the Market Vectors Coal ETF (NYSE:KOL[5]) and Market Vectors Steel ETF (NYSE:SLX[6]) had gained 17.7% and 19.5%, respectively, while the iShares Trust FTSE China 25 Index Fund (NYSE:FXI[7]) itself was up 10.4%. While this rally doesn’t make a dent in the recent underperformance of these market segments, it does indicate a major shift in investor confidence.

This reflation of investor confidence could be the difference for the emerging markets. Liquidity, on its own, hasn’t been able to spark a rally as long as investors were concerned about the European debt crisis and general economic growth trends. With these issues being forcibly removed from the table by the world’s central banks, investors are free to move out the risk curve into the emerging markets.

Those taking a fresh look at the asset class might like what they see. Although the local interest rate picture isn’t as favorable as it is in the developed world — Russia raised rates just this week — the emerging markets do offer better growth, sounder fiscal management (with a collective debt-to-GDP ratio 30% of the developed world) and lower valuations.

Even the yields are attractive: VWO has a 30-day SEC yield of 2.3%, while iShares MSCI Emerging Markets Index Fund (NYSE:EEM[8]) checks in at 2.1% and WisdomTree Emerging Markets Equity Income Fund (NYSE:DEM[9]) carries a hefty yield of 3.5%.

The most notable aspect of these yields is that investors in emerging-market bonds[10] are only getting a yield of 3.6%, as measured by iShares JPMorgan USD Emerging Markets Bond Fund (NYSE:EMB[11]). In this sense, there’s no choice: While DEM and EMB offer essentially the same yield, DEM offers long-term growth potential and relative value, since emerging equities are depressed while emerging debt is at multi-year highs.

In the short-term, the markets have rallied so much during the past few weeks that a near-term pause would seem to be in the cards. For those looking a year or more out, however, emerging-market equities look to be one of the best investment options available at this stage of the cycle.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Source URL: https://investorplace.com/2012/09/emerging-market-stocks-are-set-to-boom/

---