The Case For Higher Allocations

Several factors seem to argue in favor of maintaining commitments to emerging markets and perhaps looking instead to enlarge exposure to the asset class when opportunities present themselves. The leading factors include:

1. Globalization
2. The spread of prosperity on an unprecedented scale within developing economies
3. The transition from a long-term bear market to a long-term bull market in natural resources

Emerging markets have undergone such a dramatic transformation this decade that they bear little resemblance to their condition in the 1980s and 1990s. Financially, emerging economies have become creditors in the global economy, collectively amassing huge annual current account surpluses and controlling three-quarters of the world's foreign exchange reserves. The currency devaluations and debt defaults that plagued emerging economies in the 1990s seem like a very distant memory. Today, emerging markets are earning investment-grade ratings and their currencies are appreciating, or in the case of pegged currency regimes, viewed as significantly undervalued.

Given that the risk profile of emerging economies has improved so dramatically, it seems incongruous to apply old valuation parameters to the asset class. When the current valuation of emerging markets stocks are viewed in light of their superior growth prospects, it is hard to make the case that the asset class is overvalued. Instead, it is likely that a re-rating has occurred as a result of profoundly altered fundamentals.

What Are The Return Prospects For Emerging Markets Stocks Over The Next Five Years?

The returns on emerging markets stock indexes in the next five years will almost certainly be significantly below the extraordinary returns of the last five years. Emerging markets stocks were extremely cheap five years ago on a relative and absolute basis. Moreover, the pace of globalization and natural resource utilization that has occurred in the past five years is likely to moderate in the next five years, which will slow the growth of emerging markets somewhat.

Nonetheless, emerging markets growth is likely to exceed growth in developed economies by a substantial margin. The International Monetary Fund estimates that the developing world will grow at an average rate of 6.8% per year for the next five years, versus 2.7% for developed economies. Global companies based in developed countries such as the U.S. will capitalize on the growth of developing economies, but companies domiciled in emerging markets stand to benefit disproportionately. In addition to stronger earnings growth, emerging markets stocks should continue to benefit from rising relative valuations. It seems reasonable to expect the valuations placed on emerging markets will expand further relative to U.S. valuations over the next five years as investors seek out the best investments for capital growth and inflation protection and allocate an increasing percentage of their portfolios to emerging markets stocks.

In short, expect emerging markets stocks over the next five years to enjoy the same tailwinds they have enjoyed the past five years - namely, faster earnings growth and increasing relative valuations. This will equate to superior investment returns versus U.S. stocks. In U.S. dollar terms, emerging markets will also likely outperform foreign developed markets stocks as a group, even though the latter asset class currently enjoys relatively cheap valuations. The U.S. dollar has suffered a historic bear market against developed markets currencies and may be entering a bottoming process, which would cause currency translation to be a headwind to unhedged foreign developed markets' stock investments over the next five years. In contrast, emerging markets currencies as a group are widely viewed to be undervalued.

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