Historically, whenever a financial crisis appeared on the horizon, investors would pull out of speculative emerging markets and park their assets in so-called safe havens such as U.S.  Treasurys until the storm passed.

However, during last year’s credit squeeze, something changed. As repercussions from the subprime mortgage fiasco in the United States permeated the global financial system, emerging markets, against all historical precedent, began to boom. Investors are accustomed to seeing debt problems arise in countries such as Argentina and Thailand, but not in the United States.

With so much uncertainty surrounding the U.S. financial system, and therefore the stability of developed world economies, emerging market equities unexpectedly adopted the role of safe haven. In the middle of January 2007, a share in an exchange traded fund tracking the MSCI Emerging Markets Index, which measures equity performance in the global emerging markets, would have cost $110. At the end of October, the same exchange traded fund was pricing close to $170.  And according to Morgan Stanley, September saw the largest-ever monthly inflow of money—$15.7 billion—into dedicated emerging market equity funds. (Not everyone agrees that emerging markets hold great promise. See “A Closer Look,” page 30.)

Underpinning those inflows is the longer-term hope that emerging markets offer real value. “In these markets, consumption growth is accelerating, whereas in the United States, consumers are not going to be spending more money, but less,” explains Alex Ingham, an emerging markets fund manager at Morley Fund Management in London.

Also, emerging market economies in general are on a far more solid footing than they once were. Many of the problems that these economies experienced in the past stemmed from account deficits financed with money from the developed world—money that could quickly be withdrawn at the first hint of trouble. These days it is the emerging markets that, in aggregate, enjoy monetary surpluses, while the developed world suffers from deficits. And whereas once, investors worried about devaluations of emerging market currencies, today many of them hope that these currencies will be allowed to appreciate.

Using statistics from the International Monetary Fund, Morgan Stanley analysts estimate that emerging markets, including the Middle East, accounted for 47 percent of global economic growth last year. That is more than the United States (12 percent) and developed Europe (28 percent) put together. Moreover, emerging markets accounted for 30 percent of the global economy in 2007, versus just 21 percent in 1999.

Get on Board

The easiest way to gain exposure to this growth is through a general emerging market mutual fund or an ETF.  However, Ingham and others believe that a better way to generate solid risk-adjusted returns is to take a more targeted approach by focusing on emerging market small-cap stocks. Morley launched such a fund last year (see “Emerging Opportunities”). “If you invest in developed market small-cap, then you’re just going out on the risk curve. But with emerging market small-cap, you’re also getting much more exposure to domestic demand,” Ingham says.

Much of First World consumer demand, especially in the United States, has been driven by credit over the last 10 years. While the spending spree may be coming to an end in these countries, consumers in emerging markets are just beginning to consume. The balance sheets of smaller emerging market companies are therefore somewhat insulated from a big U.S. recession, Ingham argues.

“Emerging market small-cap tends to be less correlated to the global markets than the large-cap,” adds Bruce Lavine, the New  York–based president and chief operating officer of  WisdomTree Investments, an indexing company that launched an emerging markets small-cap exchange traded fund last year. The other perceived advantage of emerging market small-caps is that there is less analyst coverage of the sector, so there should be less competition for more opportunities.

Bubble Trouble?

Morgan Stanley describes the rising power of emerging market consumers and economies as “a permanent shift in global economic leadership.”  The key country, of course, is China. Until last year, the U.S. contribution to global nominal GDP growth was consistently much larger than China’s; in the late 1990s, it was more than five times the size of China’s. But beginning in 2003 the gap started to close rapidly. The slowdown in the U.S. economy as the credit crisis kicked in, combined with China’s continued surging growth, closed the gap completely.  The big question is whether domestic growth drivers in China and other emerging market countries will continue to feed growth or whether an emerging markets bubble has surfaced that will burst as surely as past bubbles have.

Two schools of thought have developed. Some see continued growth and no bubble. According to Morgan Stanley, public companies in emerging markets account for just 11 percent of the total global market capitalization, and this continues to trail the emerging markets’ equivalent share of global GDP by a large margin.  The reallocation of investment portfolios toward emerging markets therefore has a long way to go. However, the other school of thought says that because many emerging market currencies are linked to the dollar, the Fed’s cutting of interest rates last year in response to the credit crisis effectively imported an easing of monetary policy to these economies. This inflated already booming markets, and hence led to a bubble.

It is anyone’s guess which analysis of the market will prove correct. Although the U.S. subprime crisis quickly affected equity markets in other developed countries, it has not spread in emerging markets. That insulating quality alone makes equities in these new safe havens an attractive option. 

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John Ferry is a senior correspondent for Worth.

EMERGING OPPORTUNITIES

A number of fund managers and investment firms launched emerging market products last year to cash in on rising interest in developing economies. In particular, emerging market small-cap developed as a more easily investable asset class in its own right, with several dedicated emerging market small-cap funds appearing. In June, the index provider MSCI gave the market a benchmark when it launched the MSCI EM Small Cap Index, which covers 25 countries.

Meanwhile, Morley Fund Management launched its EM Small Cap fund in the third quarter. The fund has exposure to companies such as:

 • BIM Birlesik Magazalar, a Turkish supermarket and grocery
        retailer

• Promotora Ambiental, which provides private and domestic solid-        waste collection in Mexico

• UK-based Aberdeen Asset Management, which launched     
        its Emerging Markets fund last March

• Lloyd George Management, based in London and Hong Kong

• Santa Monica, Calif.–based Dimensional Fund Advisors, which     
        also offers emerging market small-cap products

Finally, late last year WisdomTree launched an emerging markets small-cap dedicated exchange traded fund on the New York Stock Exchange. The ETF tracks the WisdomTree Emerging Markets SmallCap Dividend Index, a dividend-weighted investment that takes exposure to small-cap stocks in 19 emerging market countries.  —JF