Last summer's downgrade of the U.S. government's credit rating, coupled with Europe's ongoing sovereign debt crisis, are just two of the most obvious signs of an ongoing shift in the balance of the world's economic power.

Industrialized nations in the West have enjoyed decades of economic prosperity and, particularly in Europe, generous social safety nets. However, recent events have made it clear that shifting demographics and huge debt burdens will make it increasingly difficult, if not impossible, for many industrialized nations to maintain the same standard of living for their citizens. It seems that many formerly emerged economies are now on the verge of submerging.

As citizens and political leaders in Europe and the U.S. slowly awaken to this reality, economies in many emerging markets are moving ahead at full steam. Many of these countries have young, growing populations, low labor costs, and burgeoning middle classes. In essence, these countries are undergoing the same kind of economic and social renaissance that many of today's leading economies experienced decades ago. Consider these facts:

• Emerging market countries currently account for 50% of the world's GDP, but only 13% of global market capitalization.
• More than half (52%) of all car sales and 82% of mobile phone subscriptions occur in emerging economies.
• More than 85% of the world's population lives in emerging market countries.
• Nearly 25% of the Fortune Global 500 companies are headquartered in emerging markets, up from just 4% in 1995.

Despite this growth and the well-publicized economic problems in the U.S. and Europe, emerging markets stocks have still underperformed the U.S. stock market and developed international markets in 2011. Year-to-date through December 2, the S&P 500 was up 0.7% and the MSCI EAFE index was down 13.1%. But the MSCI Emerging Markets index was down 17.2%. In our view, this underperformance could be a temporary phenomenon that provides an attractive opportunity to increase allocations to the world's fastest-growing economies.

History has shown that a nation's rate of economic growth plays a significant role in the performance of its equity markets. For example, between 2000 and 2010, the GDPs of Brazil, Russia, India, and China rose from 8% of world GDP to 17%. During that time, stocks on China's Shanghai Exchange more than doubled, markets in Brazil and India quadrupled, and Russian stocks were up nine-fold. Keep in mind, as always, that past performance is no guarantee of future results and the risks of investing in emerging markets include geopolitical unrest, currency fluctuations, and higher inflation rates.

As emerging nations continue to play a more prominent role in the global economy, it may be time for them to also play a more prominent role in investors' portfolios. While some investors have treated an allocation to emerging markets as an afterthought, we believe these markets can help increase diversification and provide opportunities for long-term growth.

Are The Bond Markets Trying To Tell us Something?

On the fixed income side of the ledger, yields on U.S. Treasurys remain near historic lows, as the U.S. is still viewed as the world's safe haven in a crisis. However, that's not the case in Europe, where yields on the sovereign debt of Italy, Portugal, Spain, and Greece have spiked in recent months. Italy recently paid yields of 7.89% on the sale of three-year bonds, up from 4.93% just a month earlier. In another sign of how quickly things are changing, S&P warned it might soon downgrade the credit ratings of more than 15 euro-zone countries by one or two notches.

Meanwhile, yields on many emerging markets bonds are falling as debt issued by these countries earns higher credit ratings. Over the 10-year period though September 2010, the percentage of investment-grade-rated debt in the U.S.-dollar-denominated J.P. Morgan Emerging Market Bond Index (EMBI-Global) rose from 20% to 60%. Over the past decade, debt issued by Mexico, Russia, Peru, Brazil, and Panama was upgraded to investment-grade status. Many of these countries have lower debt burdens than more developed countries. For example, in 2010, the U.S. debt load was equal to 92% of GDP, while in Brazil it was 66% and in Chile it was only 9%.

Looking to the future, economic growth in many emerging market economies is expected to grow by 5%, 6%, or more in 2012 and beyond. Meanwhile, forecasts for the U.S. range from around 1% to 2.5%. In Europe, many are forecasting a recession or anemic growth at best. The economic outlook in emerging markets bodes well for sovereign debt as well as emerging markets corporate bonds, as many companies stand to benefit from a growing local labor force and robust domestic demand. As with emerging market stocks, recent market action could be creating attractive buying opportunities for emerging market debt.

Beyond The Usual Suspects

The term "BRIC" first coined by Goldman Sachs' analyst Jim O'Neill to describe the emerging economies of Brazil, Russia, India, and China, is well known to most investors today. These nations have grown so much so fast that an argument could be made that they are no longer simply "emerging" economies, but instead should be considered "developed."

There seems to be no clear agreement, however, on the definition of "emerging" and "developed" markets, so O'Neill uses the term "growth markets" to describe fast-growing economies that constitute at least 1% of world GDP. In addition to the BRIC nations, the list includes Indonesia, Korea, Mexico, and Turkey. The combined GDPs of these nations are expected to grow by $16 trillion in the coming decade, double the amount of the U.S. and euro zone combined.

While these nations are not in the class of the G-7, some are getting close. Per capita income is now $20,000 in Korea and $15,000 in Brazil. O'Neill believes these companies are driving the world's economy and that the time to invest is before they have reached the levels of the G-7.

Other asset managers are casting wider nets beyond the BRIC nations as well. HSBC Asset Management sees opportunities in the CIVETS (Columbia, Indonesia, Vietnam, Egypt, Turkey, and South Africa), while Fidelity International has cited the MINT countries (Mexico, Indonesia, Nigeria, and Turkey). No matter what acronym you assign, it's clear there are more opportunities to invest in emerging markets today than ever, and investors are taking notice. The percentage of equity fund flows that went to BRIC countries fell from 69% in 2006 to 53% in 2010.

Our Approach

Emerging markets will always entail unique risks and higher volatility. Nevertheless, we believe that - due to favorable demographic trends, increased urbanization, and the rise of the middle class - economic growth in these countries will far outpace growth in the developed world. As this trend gains momentum, it could result in favorable returns for emerging markets stocks and bonds.  

At Emerald, we evaluate various investment classes to gain exposure to what we feel is a long-term tailwind. Among the investments we include are emerging markets bond funds, equity funds and ETFs (including thematic, broad-based, and country/region specific), and currency funds and ETFs. When we feel the value proposition is attractive, we buy. For example, we currently have allocations to emerging markets debt, currencies and a high dividend ETF. Finding valuable opportunities in this volatile category is an ongoing process and we don't just watch the changing of the guard like tourists at Buckingham Palace. We want our investors to participate, but to do so prudently and preferably with a less bumpy ride.

(c) Emerald Asset Advisors

www.emeraldassetadvisors.com

         
 

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