Look closer to home to play the emerging markets’ story

EMERGING markets have been one of the most popular trades of 2010. If it wasn’t concerns about the outlook for developed markets and the desire for higher returns further afield, it was Fed-fuelled liquidity that was driving flows towards the developing economies.

The case for investing in equities rather than bonds is becoming stronger by the day. Indeed, strategists reckon that we are in a sweet spot for equities because of improving growth, near-zero interest rates, high profit margins, strong corporate balance sheets, historically high equity risk premiums, and a new flood of central bank liquidity.

Yet the case for investing in emerging market equities has become less clear-cut. Investors and policymakers are becoming more worried about the emergence of asset bubbles fuelled by cheap liquidity. To counter this and the looming spectre of inflation, authorities are looking to tighten monetary policy. While there is the potential for some offset to this risk to come in the form of emerging market currency appreciation, this process is not expected to be smooth.

Consequently, strategists at Barclays Capital suggest that investors ought to “pare back exposure to the developing world in favour of developed world companies with significant exposure to emerging economies” at least for the first half of 2011. This is especially because of the “considerable capital flows into illiquid markets in the second half of 2010 and expected increases in volatility,” they say.

Investors using exchange-traded funds (ETF) as the building block of their portfolios should take note and perhaps look to cut back their emerging market ETF positions. It is difficult to select developed world firms with exposure to the emerging markets via ETFs. But there are certain sectors that will benefit from international growth, says Michael Hartnett, chief global equity strategist at Bank of America-Merrill Lynch. Technology, energy, industrials and materials are four global cyclical sectors that he suggests being overweight: “The global cyclical sectors benefit the most from EM-led global growth, rising infrastructure spending and recovering business spending.”

In Europe, the preferred sectors are basic resources and energy while Bank of America-Merrill Lynch is overweight healthcare because of the combination of high dividend yield, reinvigorated management and favorable long-term prospects based on underrated EM exposure and demographics. Lyxor offers global sector ETFs with a total expense ratio of 0.45 per cent while BlackRock’s iShares provides both US and Stoxx Europe sector ETFs.

Hartnett would nonetheless recommend staying long of emerging market equities but advises choosing large caps rather than small caps. For ETF holders, this should not be too difficult as the majority of emerging market benchmarks consist mostly of liquid large cap names. “We would need to see significant downgrades to Chinese growth for emerging market equities to fall in absolute terms in 2011,” he concludes.

With emerging equities’ potential capped by fears about asset bubbles, at least in the early part of 2011, it may be cheaper for ETF investors to select developed market sectors exposed to the emerging market growth story.