Emerging Markets Go on a Tear

Investors Ignore Possible Pullback and Focus on Longer-Term Strength

JOANNA SLATER

For all the talk about the sharp rebound in U.S. stocks in recent weeks, shares in emerging markets have been on an even bigger tear.

That is making investors nervous that these shares could experience a major pullback in coming months, though it hasn't stopped them from buying companies they believe will end up stronger over the next year or two.

As they wade back into riskier assets, investors have flocked to places like Brazil, South Korea and Russia, where stocks, bonds and currencies were crushed in last year's market turmoil.

Investors watch the electronic display board at a stock exchange in Yichang, China, in February.

Investors have pinned their hopes on signs that the tumble in China's economic growth has been arrested and might be reversing. New loans in China hit a record in March, as did monthly car sales. There are also indications that the pace of decline in industrial output may be stabilizing in other developing countries.

These markets got a further boost earlier this month, when the Group of 20 nations agreed to pump up the resources of the International Monetary Fund to $1 trillion from $250 billion. This gives the IMF the ability to ward off sizable financial crises in developing countries, which provided investors with a degree of comfort.

So far this year, emerging markets are the world's best performers. A Morgan Stanley index tracking emerging-market stocks is up 12% in dollar terms. By contrast, its index following stocks in developed markets outside the U.S. and Canada is down 9%.

Even after recent gains, the Dow Jones Industrial Average is down 7.9% so far in 2009. (The market reopens on Monday after a three-day break including Good Friday.)

Benchmark stock indexes for China, Russia and Brazil, meanwhile, have soared more than 20% this year in local-currency terms, while India's index is up 12%.

Governments and even a few companies in emerging markets have taken advantage of the easing in investors' worries to issue debt. Currencies also fared well, with the Mexican peso, Brazilian real and Russian ruble all gaining 7% or more against the dollar since the start of March.

But navigating through the burst of optimism is a challenge for investors. "Everybody has just piled in, and [the rally] has been remarkably quick," says Simon Hallett, who manages about $3.5 billion in global stocks at Harding Loevner in Somerville, N.J. "A lot of it is reliant on a belief that China has fixed its problem."

Mr. Hallett says he was shaken by terrible economic data coming out of emerging markets earlier this year but was reassured that, apart from certain countries in Central and Eastern Europe, financial systems "bent but didn't break."

He says that his firm is planning to increase its position in emerging markets in the coming months.

Such stocks could stumble hard if there were a new downdraft in global markets. Like all riskier investments, assets in these countries remain hostage to investors' willingness to take chances. Should that change, money once again could flow rapidly out of these markets.

Recent news from some emerging markets highlights the uncertainties. Just this weekend, protests against the government of Prime Minister Abhisit Vejjajiva in Thailand erupted into chaos and ousted leader Thaksin Shinawatra threatened to lead a mass uprising. As Turkey inches closer to a deal for a loan from the IMF, it is under pressure to reduce its budget deficit and revamp its tax system.

The sectors leading the current rally in emerging makets are a reason for caution, says Devan Kaloo, who manages $7.5 billion in emerging-market stocks at Aberdeen Asset Managers in London. Those that have fared best, like energy, materials and technology, are pinned to hopes for global growth and helped lead the way during the bull market.

"You generally know you've reached a bottom when people give up on the darlings of yesterday," Mr. Kaloo says. "The fact that the rally has been led by the same sectors and hasn't been so broad makes me concerned."

For the longer run, however, he believes stocks oriented toward domestic consumption in these countries will win out. He took advantage of last year's selloff to stock up on shares he hadn't owned in the past because he considered them too expensive, such as Indian software company Infosys Technologies and Standard Chartered Bank, a U.K. firm that focuses on emerging markets.

Mr. Kaloo and others say problems in these countries are related to a temporary slowdown in economic growth, more than deep-seated issues like excessive debt and troubled banking systems.

That means they could bounce back from the current economic crisis faster than their developed counterparts.

"It's one of those times where you run a $7 billion fund, and you wish you had more money," says Justin Leverenz, an emerging-markets portfolio manager at OppenheimerFunds, who adds that he hasn't felt this optimistic about emerging markets for a decade.

That is because these markets are no longer trading at sky-high prices, as they were before last year's selloff. Now, Mr. Leverenz says, he can buy companies he has long coveted, like Enka, a Turkish construction company whose market capitalization dropped by half over the past year. He also bought back shares of Cyrela Brazil Realty, a property company he sold last summer when its price was roughly three times what it is now.

While he admits it is unclear how these shares will fare in the next three to six months, he sees considerable upside over the next year or two as investors comb the globe for economic growth, something he believes will be in scarce supply outside developing countries.

Such stocks now are cheap relative to recent years, although valuations have perked up from the depths of late 2008. Shares in emerging Asian markets are trading at about 13.5 times estimated earnings in 2009, while in Latin America the same ratio is 9.5 times per-share earnings, and in Central and Eastern Europe the figure is eight times, according to a recent Citigroup report.

Earnings-per-share are forecast to fall 7% this year in emerging Asia and 20% in Central and Eastern Europe but to rise 3% in Latin America.

Still, the economic picture is cloudy enough that a number of investors say it is worth adopting a more nimble approach in the short run. Curtis Mewbourne, co-head of emerging markets at bond giant Pacific Investment Management Co., says the firm picked up debt issued by Russian government-owned companies into the end of last year, when it was trading at distressed prices.

Such debt enjoyed a strong bounce over the past few months, producing a healthy return of more than 10%. But rather than stay with the position, the firm sold and locked in the gain.

Dan Chamby, a portfolio manager for BlackRock's Global Allocation Fund, says emerging markets face a difficult transition before they can power their own economic growth. His fund has loaded up on bonds that can be converted into shares in these markets, since they provide regular income and some degree of protection to investors in a worst-case scenario.

The fund has 17% of its portfolio in emerging markets, a big bet, and about a third of that is in convertible bonds.