Why 20% of my equity portfolio is in emerging markets

I've often made the case for investing in the emerging markets (EM) here in The Right Side. Alongside precious metals and bonds, I see EMs as an essential part of my long-term wealth-building game plan.

And it's not necessarily for the reasons you might think. Today I'll tell you my real motivation for putting a decent amount of my savings into emerging markets.

See, I think many investors dive into EMs for the wrong reasons. They just see near double-digit GDP growth figures for places like China or India and think those markets are a must-have for their portfolios.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

And that's understandable. I mean, an economy firing on all four cylinders must be great for stocks, right?

Well, not necessarily.

As my colleague Cris Sholto Heaton recently pointed out, data from the IMF and MSCI suggests the relationship between GDP growth and stock market performance is actually very weak if it exists at all.

The fact is you can have an economy that is going like the clappers but that won't necessarily deliver you stock market returns. Cris suggests that's because investors end up shelling out too much for these growth stocks by paying bubble prices. And that's a good point.

But I've got another idea. Today I want to show you why it's not inconsistent for growing economies to deliver poor stock market returns.

More importantly I want to suggest why this doesn't matter right now. There is in fact an even better reason why I think you need a foot in the emerging markets camp.

But first

This is where so many EM investors go wrong

China is producing more and more millionaires every year. The number of individuals with investable assets of more than $1m is quickly catching up with the US. It makes sense. In a burgeoning economy, businesses are created every day and that means more wealthy entrepreneurs.

In a healthy economy new firms provide competition. And healthy competition means profits are what economists like to call normal'. When profits are normal, no single firm dominates, lapping up outsized profits.

That's why it's totally conceivable that company profits don't ramp up just because an economy is firing on all cylinders. When competition is strong, there's no reason why valuations should fly.

In fact you could argue the opposite is true. That is, in a mature economy like the UK or US, barriers to entry gradually grow. In the West, massive multinational firms predominate. The big boys snap up competitors and brush aside new entrants. Lack of competition can lead to super-normal' profits. And that could all be pretty bullish for the markets!

So far, so good. But hang on because there's an illness at the heart of most mature economies...

Why currency is key for EM investors

I've got a growing unease about the health' of the West.

Sure, mega-business can increase profits, but they do it by squeezing out opportunities for others. It's not healthy for the economy as a whole...

And it's not just mega-business that's taking its toll on the economy. It's the growing intervention of government too. Government red-tape means that small businesses struggle to get going.

I'm delighted to hear David Cameron's ideas on cracking down on The madness of European red tape'. But frankly, as a small business owner, I'm yet to see any evidence of it. (I'd be interested in knowing how other business-owning Right Siders feel on that let me know by commenting at the end of this article)

My point is that, together, Big Business and Big Government have a pernicious and stultifying effect on the economy. Just look at Europe by gum, there's an advert for reining in multi-national government!

Ultimately the effects of a weakened economy show up in foreign exchange rates. This is an ominous sign for the Western developed economies we've seen it before in emerging markets currencies.

For decades bad macro-policies in the developing world have caused its currencies to be volatile and generally weak. Over time they've generally drifted against the strong currencies of the West.

But now what's happened? The situation has reversed.

Here's a chart produced by the London Business School and Credit Suisse. It shows EM currency volatility (relative to the $US) since 1972.

The recent stability is striking. The yo-yoing spikes show how volatile EM currencies have been in the past. But recent years reveal a much calmer picture...

Stability: the long-term EM trend

EM currencies ain't what they used to be. And neither are the currencies of the West!

Without a stable currency, businesses don't like to invest in a country for the long term, and contracts are more difficult to pin down.

But it's not just that. Over the last ten years or so, EM central banks have started to build tremendous foreign exchange reserves. At the same time, the West has built up what you might call negative reserves (debt and lots of it!).

The point is, EM currencies are strengthening. I suspect that to be a theme for at least the next decade. EM will continue to do well as the West grapples with an inefficient corporate and government set up. And that's not to mention the debt and demographic problems we have...

I'm aiming for a good 20% of my equity allocation to be invested in EMs. And remember, that's not just because of better growth rates. This is because I want to hedge against sick old Western markets.

I've mentioned ways of playing EMs through two investment trusts in the past. You can read more about JP Morgan's emerging market fund and the Ashmore Global Opportunities trust by clicking on the links.

And if you want to stay abreast of developments and investment ideas in EM, then sign up to MoneyWeek Asia. It's a great read. And it's free. Sign up here.

For me, emerging markets are a major opportunity and I'm always on the look for good ways to get exposure. If you have any good ideas to share, let me know. Or just let me know what you think about EMs you can leave your comments below.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

Important Information

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Managing Editor: Frank Hemsley. The Right Side is a regulated product issued by Fleet Street Publications Ltd.

Fleet Street Publications Ltd is authorised and regulated by the Financial Services Authority. FSA No 115234. https://www.fsa.gov.uk/register/home.do