Even after gains, emerging markets are top picks

A growing middle class unburdened by the excessive debt plaguing Western consumers means emerging markets still offer plenty of opportunities to make money next year even after a meteoric rise in 2009.

Money managers at the Reuters Investment Outlook 2010 Summit this week were particularly bullish on Asian economies with high savings rates and on Brazil. Some said the maturity of Brazil's financial markets means it almost has "emerged" and joined the ranks of more developed economies.

Bob Doll, vice chairman of Blackrock Inc, said the "absence of the debt noose around the neck that much of the developed world has" makes emerging economies promising places to invest, despite a 70 percent gain in the broad MSCI emerging markets index in 2009.

Others highlighted a growing middle class, a high savings rate, commodities wealth and room for increased consumer spending as factors favoring emerging market exposure in 2010. 

Economies with low levels of consumption as a percentage of gross domestic product such as Brazil and China "are economies that can grow and grow and grow," said Bill Gross, co-chief investment officer at Pacific Investment Management Co., the world''s biggest bond fund.

In Brazil, "less than 20 percent of the population uses the financial service system," said Diane Garnick, investment strategist at Invesco. "They don't even have a bank account, so that in my mind creates a scenario where they are going to grow a lot faster."  

Gift that keeps giving                           

Such enthusiasm is hardly new. In the darkest days of the financial crisis in 2008, investors dumped all emerging market assets and currencies with abandon and sought safety in short-dated U.S. Treasuries and cash.

But since March, emerging assets have been in high demand as investors began betting that the biggest emerging economies would lead a global recovery.

Brazil's benchmark stock index, the Bovespa, has gained nearly 80 percent this year and still has a 12-month forward priceearnings ratio below that of the S&P 500, according to Thomson Reuters data.

According to fund tracker EPFR Global, as of mid-November, emerging market equity funds had attracted a net inflow of $60 billion in 2009, shattering 2007's record of $54.3 billion. 

Metals and oil have also had a steady run higher, which along with high interest rates helped boost currencies of commodity-rich countries such as Brazil, South Africa, Chile and others.

Of course, while high savings, low debt and mature debt markets have certainly helped burnish emerging markets' appeal, all the easy money the Federal Reserve and other developed central banks have poured into the economy hasn't hurt either.
 
"I view those flows as speculative," said veteran Wall Street economist Henry Kaufman. "You will notice that when there is a period of tightening credit conditions those emerging countries do very poorly." 

Capital controls vs Easy money                                

Tighter conditions may still be quite a ways off, though, according to most money managers at the summit. Gross said sluggish U.S. growth means the Fed likely won't hike rates from record lows near zero percent until 2011. Few expected imminent hikes in the euro zone or Japan, either.

Not all emerging markets are of equal appeal, either. Jim Rogers, who rose to fame after co-founding the Quantum Fund with George Soros nearly four decades ago, said he likes Brazil and fiscally prudent countries such as China but dislikes India because the bureaucracy is stifling. 

He also said he avoids Russia because investors can end up "broke and dead." 

Punitive taxes and other capital controls designed to slow "hot money" inflows are also a risk and are looming larger on investors radar screens after Brazil slapped a 2 percent tax on foreign equity and fixed-income purchases last month.                                            Brazil said the economy grew 1.3 percent in the third quarter this year, below a 2 percent forecast, and some economists have blamed the strong real, up about 24 percent against the dollar this year.  

Taiwan and Korea have adopted similar measures and many emerging central banks have intervened to weaken their currencies relative to the dollar. 

A strong currency can increase the cost of exports, which many emerging economies rely on to drive growth.

"Capital controls are points of pretty significant concern," said Max Darnell, chief investment officer of First Quadrant, with $18 billion in assets under management. "Impediments to trade in these markets is very worrisome to me." 

Still, Darnell said First Quadrant plans to open a fund that invests in emerging market currencies and is particularly bullish on Brazil's real.  

Jonathan Xiong, who helps manage about $18 billion in currency assets at Mellon Capital Management, said the impact of recent capital controls should be short-lived. 

"I think a lot of these investors who are investing in emerging markets -- hopefully they realize some of the risks -- are in for the longer-term play," he said.