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Pummelled emerging markets offer growing temptation

To investors shell-shocked by the carnage on North American stock markets last quarter, one fact is easy to overlook: losses in emerging markets were twice as bad.

While Canada's benchmark S&P/TSX composite index dropped 12.6 per cent in the three months ended Sept. 30, the MSCI Emerging Markets index tumbled 25 per cent.

Some observers now argue the selloff in emerging markets from Colombia to Brazil and Indonesia to South Korea has gone too far and opportunity exists for those brave enough to jump back into the bonds and stocks of these rapidly growing nations.

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"I would rather own Brazilian debt than [U.S.]T-bills," says Jurrien Timmer, director of global macro for Fidelity Management & Research Co. "There is nothing wrong with emerging markets' fundamentals."

Among those attractive fundamentals are healthy trade surpluses and relatively low budget deficits, as well as younger populations and faster growing economies than those in North America or Europe.

To be sure, there are risks. Emerging market stocks trade on exchanges far smaller than those in developed nations, with fewer large buyers and sellers. As a result, these stocks can shoot up and down in dramatic fashion. The tradeoff for this volatility, however, is often faster growth and lower valuations.

Mr. Timmer, who co-manages Fidelity's Global Strategies Fund, thinks a lot of the recent selloff in China and other emerging market stocks came as a result of carry trades by hedge funds. In a carry trade, sophisticated investors borrow money in countries with low interest rates and put the money into higher-yielding assets in other countries, betting that their gains won't get erased by a sudden change in exchange rates.

When global markets began to sink this summer, hedge funds playing the carry trade were forced to come up with more cash to cover their leveraged positions. They began to sell holdings, especially in riskier assets such as emerging markets stocks. As a result, those stocks suffered far steeper losses than those in developed nations.

On a price-to-earnings basis, emerging market equities are now better value than those in developed markets, according to Pierre Lapointe, global market strategist, and Alex Bellefleur, financial economist, at Brockhouse Cooper.

The MSCI Emerging Markets index traded recently at 9.3 times earnings, below traditional norms, and also below the 11.5 multiple for the MSCI World index of developed markets. Emerging market stocks, as a group, are generating a dividend yield of 3.1 per cent, far above the long-term average of 2.2 per cent.

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The bottom line, say Mr. Lapointe and Mr. Bellefleur, is that emerging market equities are set to deliver real returns of about 9 per cent a year over the next five to seven years, compared with 4 per cent to 5 per cent in the U.S. and Europe.

The Brockhouse Cooper pair also see opportunity in emerging market debt, following a 6-per-cent decline since August. Investors have sold emerging market debt "somewhat indiscriminately" in favour of the perceived safety of U.S. Treasuries and German bunds.

"At some point, market prices will have to catch up to the fundamentals, which in our view remain strong," they wrote in a report published Thursday. "We think the price action in [emerging market]debt is somewhat out of line with the fundamentals of the asset class."

Governments in emerging markets have less than half the debt burdens of developed nations, yet their bonds offer more than twice the yield. In addition, years of trade surpluses have allowed them to accumulate large amounts of foreign exchange reserves, which serve as a buffer against shocks.

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