Emerging Markets: The Trend is Your Friend

S&P believes the emerging markets equity rally is supported by superior fundamentals

Emerging market (EM) equities advanced 33.5% year-to-date through Oct. 1, dwarfing far more modest gains for most developed markets. While there are concerns the rally can't be sustained, we expect the group to continue to outperform.

Our bullishness is based on the growing global economic clout of emerging markets. As their domestic demand has soared and trade among developing nations and with Europe has increased, EM countries are less reliant on exports to the United States, and hence less vulnerable to a housing-driven U.S. slowdown, by our analysis. This is fueling strong earnings gains, which, combined with low relative valuations, is likely to maintain healthy returns, in our view.

According to data from the International Monetary Fund, in 2006, emerging economies like China, South Korea, India, Brazil, Mexico, Russia, South Africa, and others accounted for 48% of global gross domestic product (GDP) and 69% of global GDP growth. In our view, this trend is only accelerating in 2007.

As for 2008, while we forecast only 2%, 2.2%, and 2% real GDP growth in the United States, Europe, and Japan, respectively, we expect 7.8%, 6.2%, 5.7%, and 4.7% expansion for Asia ex-Japan, emerging Europe, the Middle East & North Africa, and Latin America.

Standard & Poor's Equity Research believes favorable EM demographic trends, increased industrialization and urbanization, and growing consumption of finished goods and services are responsible for the shift in global growth leadership. We expect these trends to continue for decades to come.

By 2050, the United Nations estimates the working age population (15-64 years) of developing countries will climb to 5.1 billion, up 52% from 3.37 billion in 2005. Conversely, the developed world's labor pool will decline 11% to 730 million from 823 million in 2005.

In addition, as emerging markets transition from agricultural to service- and manufacturing-based economic models, we think industrialization will rapidly expand. We believe industrialization is leading to unprecedented EM urbanization, as workers migrate away from farms towards factories and offices that tend to be located in cities. This urban migration is shifting the balance of power in global consumption growth from the U.S. consumer, the historical stalwart, towards EM, where per-capita incomes are rising sharply as the urban middle class expands, by our analysis.

Consensus forecasts call for 2008 EM earnings growth of 13.7% vs. a 7.8% gain for developed overseas stocks and a 12.2% increase in the S&P 500. Despite higher projected profit growth, EM valuations, at 13 times estimated 2008 earnings, are lower than those of both U.S. (14.3 times) and developed overseas equities (13.2 times).

While the pace of future gains will likely moderate, S&P believes the bull market in EM equities has further to run. We think EM equities should represent a core, long-term holding in U.S. investor portfolios. The S&P global asset allocation dedicates 5% of our 60% recommended worldwide equity weighting to diversified EM equities (ETF: EEM).

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