Emerging Markets’ Troubles May Pull U.S. Investors Home

Return to the First World?

For investors, that may be the clarion call resounding from Mexico’s deepening financial crisis. As plunging Latin American share prices worsen an already lousy year for “emerging markets” stock owners, the lower-risk allure of U.S., European and Japanese securities may grow.

Some analysts believe that U.S. stocks and bonds in particular are poised to benefit as Americans--and other global investors--reconsider the hazards versus the potential rewards in committing money to far-off and usually illiquid Third World markets.

Mexico’s stunning currency devaluation and seeming loss of financial stability since last week have been unnerving even to professional emerging-markets investors, because until this year the country had been considered one of the greatest foreign-market success stories.

“I don’t think one can ignore that Mexico was seen as one of the more blue-chip emerging markets,” said Richard T. Saler, manager of the Lexington Worldwide Emerging Markets stock fund. With the Mexican market now down nearly 40% this year in dollar terms, “To pretend that it’s not going to have an impact (on investors’ attitudes) is kidding oneself,” he said.

It was on the heels of the Mexican stock market’s tremendous 1988-92 gains that emerging-markets investing in general became fashionable in 1993, leading to a spectacular surge in purchases of foreign stock mutual funds.

International funds, which took in $5.1 billion in new cash in 1992, saw $26.3 billion pour in during 1993. And through October of this year, the inflows kept up a record pace, reaching $26.7 billion.

The assets of emerging-markets stock funds alone, which had totaled a mere $600 million at the end of 1992, ballooned to $10 billion by last Sept. 30, says fund-tracker Lipper Analytical Services.

But after huge stock gains in 1993, the continuing inflow of cash into emerging-markets funds hasn’t been matched by performance this year, despite a summer rally in many of those markets.

The average emerging-markets stock fund plunged 12.6% in the first half of the year, according to Lipper, as the Indian uprising in Mexico’s Chiapas state last January and the fallout from rising interest rates worldwide slammed many Third World markets.

In the summer, a rebound in Mexico and other major emerging markets erased the first-half loss, but the gains proved fleeting. By last Thursday, as other Latin American markets slumped with Mexico, the typical emerging-markets fund share owner was down 10.6% for the year.

In contrast, the average U.S. stock fund is off about 2.5% this year, while the average diversified international fund (many of which invest mostly in major foreign markets) has lost a mere 1.5%.

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It has been possible to make money in emerging markets this year. But the biggest gainers have been some of the smallest and least liquid of world stock markets--places where most mutual funds would have very little invested. Bangladeshi stocks, for example, are up nearly 114% this year. The tiny Peruvian market is up about 51%.

On the flip side, the year’s big losers have included markets that, like Mexico, had been touted as particularly promising in the 1990s: China, where the Shenzhen market index has plunged almost 64%; Hong Kong, off 30%, and Malaysia, which has lost about 19%.

Of course, any investor taking a chance in high-risk emerging markets should in theory be prepared for raucous volatility. What’s more, the give-back in Third World stock prices this year has been relatively small compared with 1993’s gains: The Fidelity Emerging Markets fund, down 19% this year, was up 82% in 1993.

But with this latest and more terrifying decline in Latin American stocks, some investment pros worry that the public’s patience is wearing thin. “What concerns me is that much of the money (in emerging-market funds) may have been invested by people who had no idea what could happen” when trouble hits, said Madelynn Matlock, manager of the Bartlett Value International stock fund.

Just as a surprising number of municipal bond fund investors bailed out of those funds in the wake of Orange County’s bankruptcy this month, managers of emerging-markets funds worry about a delayed reaction to the Mexican crisis.

Fears of heavy shareholder redemptions in international funds in early January have kept the Lexington fund’s Saler from bargain hunting in Latin markets, he says; if fund investors begin to exit in droves, the carnage in the Mexican, Brazilian and Argentine markets could worsen.

Meanwhile, even though investors have been conditioned to buy when markets plummet, the relative attraction of most emerging stock markets is dimming for another reason: U.S. stocks, bonds and money market investments, and their counterpart investments in Europe and Japan, have become much more enticing for global investors.

The surge in short-term U.S. interest rates has lifted the yield on one-year U.S. Treasury bills to 7.2%, an extraordinary risk-free return.

At the same time, long-term U.S. bond yields--and European bond yields--are coming down as more investors assume that both economic growth and inflation in 1995 will be moderate. A continuing bond rally could draw in an increasing number of risk-averse, yield-hungry investors.

For U.S., European and some Japanese stocks, the renewed attraction is the prospect of another gain in corporate earnings in 1995, with stock prices now at reasonable valuations after this year’s declines. Indeed, with many First World and Third World stocks now priced in the same range--at 11 to 15 times estimated 1995 earnings per share--investors may logically ask whether the risk inherent in Third World markets makes them relatively overpriced.

In the long run, there’s no question that emerging markets should offer higher returns for higher risk. But near term, the message of Mexico may be that the glory days of emerging-markets investing have run their course.

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Riding the Tigers

The “emerging” stock markets have been a mixed bag in 1994, with the biggest gains occurring in some of the least liquid markets.

Biggest Gains

1994 chng. Market in dollars Bangladesh +113.9% Peru +50.8 Brazil +48.1 Chile +47.9 Nigeria +40.8 Portugal +24.3 Colombia +23.0 South Korea +20.9 India +17.2 Taiwan +15.8

Biggest Losses

1994 chng. Market in dollars China (Shenzhen) -63.5% Turkey -49.1 Poland -48.5 Mexico -39.4 Israel -32.1 Hong Kong -30.2 Argentina -24.1 Indonesia -23.8 Czech Republic -23.1 Malaysia -18.6

Data through Monday, based on principal local stock market indexes adjusted for currency fluctuations.

Source: Montgomery Asset Management