McCall’s Call: Emerging Markets Breather

February 16, 2011

The emerging markets may be cooling off, but that doesn’t mean you should write them off.

 

The emerging markets have been the place to invest in the past decade, as developed nations struggle to achieve minimal gains for investors. EEM, the most heavily traded emerging markets ETF, came close to tripling in the seven years ended last year, while SPY, the large-cap U.S. equity ETF, rose just 14 percent.

IU_MattMcCallColumnHowever, the tides have been changing, with the iShares MSCI Emerging Markets ETF (NYSEArca: EEM) down 4 percent through the first six weeks of 2011, and the SPDR S&P 500 ETF (NYSEArca: SPY) SPY gaining 6 percent.

There are plenty of reasons for the shift, including rising inflationary pressures throughout the emerging markets. Also, a renewed concern among investors that political instability in the developing world, such as the world has witnessed in Egypt, is all too real, and can hurt returns.

The deeper question is whether this pullback marks the end of the decade-long bull run in emerging markets, or are we looking at a brief setback before prices start rising again?

My best guess is that the emerging market juggernaut is intact over the longer term, but that investors need to pick their spots in the near term. The broad array of single-country ETFs now on the market make this challenge easy to meet for investors looking to buy on the dip in rapidly expanding countries such as India.

Egypt Revolt

Protests in the streets of Cairo were unforeseen and rocked the world of emerging market stocks and ETFs. For over two weeks, Egypt was basically out of business as the protesters shut down major roadways and stopped going to work. With the resignation of its president, Hosni Mubarak, the Egyptian military is in control of the Middle East’s most populous country, and life is starting to get back to normal.

The unrest opened many investors’ eyes to the high political risk associated with emerging market countries, and not just Egypt.

Even though there’s great growth potential in emerging market nations, the risks accompanying such investments don’t really apply to developed countries such as the U.S. and Western Europe. The recent flows of investment dollars to well-established economies, in part, reflect this.

China Rate Hike

Even before Egypt provided a reality check for emerging market investors, the Chinese government recently hiked its benchmark interest rate by 25 basis points, the third such hike since last October. This move is in response to rising commodity prices, which has led to fears of inflation in the booming nation, which surpassed Japan last year as the world’s second-biggest economy.

Increased demand around the globe for food; industrial materials such as copper or oil; and other important commodities like cotton have pushed prices of many commodities to multiyear highs, increasing inflationary pressures in emerging market countries.

China is not the first country to raise rates, and it may actually be considered late in its tightening efforts. Since the beginning of 2010, Brazil has raised interest rates from 8.75 to 11.25 percent; India’s benchmark went from 4.8 to 6.5 percent; and Indonesia increased its rate by 25 basis points to 6.75 percent.

 

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