Emerging Markets and Inflation for 2012

 | Dec 28, 2011 | 3:30 PM EST
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I see two emerging trends of interest in 2012. The first is the realization that the global economy is no longer driven by the US or other developed markets, but by those economies in Asia outside Japan and in the global emerging markets. The second is that growth outside the US and continued monetary and fiscal stimulus around the world will eventually lead to renewed inflation which should start to come back later next year.

As in 2008, the GDP growth forecasts in the table below show that the general global macroeconomic and financial market environment is characterized by the birth of what Morgan Stanley calls the Asia/emerging market-centric global economy. Led by China, emerging markets are taking a dramatically rising share of world manufacturing output. Emerging markets' share of global nominal USD GDP is now forecast to be level with that of developed markets by 2016 (under IMF definition of GDP). As shown in the table, global GDP growth is forecast at 3.5% in 2012 consisting of 1.2% growth in the G10 developed countries offset by 5.7% GDP growth in emerging markets and 6.4% in Asia excluding Japan.

In addition, the emerging markets and Asia excluding Japan remain in an earnings-driven secular bull market. During the course of 2011the MSCI Emerging Market USD EPS has set a new post-global-recession high. It is forecast to be some 6% well above the prior peak, outperforming other regional equity indices in this regard. Moreover, the proposition that MSCI Emerging Markets remains in a secular bull market is supported by the longer term trend. Of the major equity regions, the MSCI Emerging Markets is the only one to show a positive CAGR in USD total returns over the three-, five- and 10-year time horizons.

Given GDP and earnings growth potential the emerging markets and Asia excluding Japan should be the place to be in 2012, global investment flows and increasing allocations of institutional investors around the world will also continue to drive these markets. For broad exposure to the emerging markets worldwide, I favor the Vanguard MSCI Emerging Markets ETF (VWO).  VWO gives exposure to more than 800 securities from 26 emerging market countries.   From an asset allocation standpoint, I see VWO as a key long-term holding and would increase my exposure from a tactical viewpoint.

For exposure to Asia-Pacific excluding Japan, I favor the iShares MSCI All Country Asia ex Japan Index Fund (AAXJ), which consists of stocks from the following developed and emerging market countries: China, Hong Kong, India, Indonesia, Malaysia, Pakistan, Philippines, Singapore, South Korea, Taiwan, and Thailand.

The second emerging trend I see for later in 2012 is the reemergence of inflation and higher commodity prices. This is also related to the first theme of growth in the emerging markets and parts of Asia driving global growth. The growing counties have much higher inflation than the developed countries and they are likely to export this as their exchange rates change. The economic growth in the rest of the world is also going to drive commodity prices higher. Growing populations in the developing world are consuming all forms of commodities from food to oil to metals as their incomes rise. Higher oil prices are also likely a factor with continued political instability in some major oil-producing countries including Libya and Iran.

In addition, years of free money in the developed world has to ultimately bring back inflation. Finally, I think consumers have pent-up demand and will start spending again resulting in higher prices from higher demand. 

For general protection against inflation I favor the PIMCO 1-5 Year U.S. TIPS Index Fund (STPZ). STPZ has price volatility and less sensitivity to changes in interest rates than other ETFs investing in Treasury Inflation Protected Securities. My view is that both inflation and interest rates will go up in next year and I favor shorter-term TIPS ETFS such as STPZ.

Another ETF alternative using a multi-asset strategy to protect against inflation is the IQ Real Return ETF (CPI). CPI seeks to provide a hedge against the U.S. inflation rate by providing a real return, or a return above the rate of inflation, as represented by the consumer price index. CPI is a Fund of Funds that buys other ETFs to achieve its investment strategy.

My favored investment for a long-term exposure to commodities is the PowerShares DB Commodity Index Tracking Fund (DBC). DBC invests in commodity futures seeking to track the Deutsche Bank Liquid Commodity Index. It is a rules-based index based on 14 commodities that rebalance each November to the following base weights: energy (55%), precious metals (10%), base metals (12.5%) and agricultural commodities (22.5%).

I also believe investing in commodity-related equities is an attractive way to get long-term exposure to commodities. Commodity-related equities can complement holdings in futures based ETFs such as DBC or serve as one's sole allocation to commodities. For exposure to commodity related equities, I favor the IQ Global Resources ETF (GRES).



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