Don’t Neglect the Emerging Markets

From The Charleston Mercury, February 7, 2013:

financial advisors, asset allocation

Yes, 2012 was a great year for U.S. equities. The S&P 500 index rose 13%. However, did you know that the MSCI Emerging Markets Index was up 15%? Emerging market results were uneven. Turkey and Thailand had exceptional performance. China and India did well. Chile and Indonesia did poorly.

Bond returns in the U.S. were lower in 2012; the U.S. Aggregate bond index was up 4%. Not so with emerging market bonds. The JP Morgan Emerging Market Bond Index returned 18% in 2012 (11% per year in the last decade.) Even countries like Mongolia, Zambia and Bolivia are issuing sovereign bonds and receiving favorable terms. The world is changing every day.

You and your financial advisor should consider including emerging markets as a small part of your diversified core portfolio of stocks and bonds. Here’s why:

The demographics are great in the emerging countries. They have an expanding middle class, low debt to GDP and improving credit quality. Growth prospects in emerging countries are much better than developed countries. The IMF forecasts an increase in GDP in emerging markets from 5.3% in 2012 to 5.5% in 2012. Developed countries will likely be around 1%. 

An additional reason for considering an allocation to emerging market stocks includes current valuations. Emerging market stocks are selling for around 12 times earnings for the past 12 months versus roughly 16 times for S&P 500 stocks. 

Emerging market bonds are certainly a more risky investment than the bonds that compose the U.S. Aggregate bond index; which is roughly 2/3 U.S. treasuries and agencies and 1/3 corporates. With a credit quality rating generally comparable to high yield bonds, emerging market bonds would be expected to produce a higher return. However, some of the emerging market countries are stabilizing and, in fact, receiving upgrades in their government bond ratings, while the ratings of some developed countries are being downgraded.

Certainly, there are risks with emerging market securities. First, we are interconnected in the global economy. When growth stagnates in mature countries, this has a direct impact on emerging markets. Second, emerging market stocks and bonds are more volatile. During the last bear market from April, 2011 to October, 2011, the MSCI Emerging Market Index plunged 28%, while the S&P 500 index dropped 19%. In a flight to safety, both emerging market stocks and bonds will likely fare worse than domestic stocks and bonds.

Even so, don’t neglect to allocate a small part of your portfolio to emerging market securities. Over the long-term, you should be well rewarded for your foresight and incurring slightly more risk on a small portion of your portfolio.

Les Detterbeck is one of a small number of investment professionals in the country who has attained CPA, CFP®, and CFA designations. His firm, DWM Financial Group, Inc., a fee-only Registered Investment Adviser, has offices in Charleston/Mt.Pleasant and Chicago. Les may be contacted at (843)-577-2463 or les@dwmgmt.com