Emerging Markets Appear Vulnerable

Emerging markets appear vulnerable compared to the developed international markets. For instance, China is currently facing an inflation spike (+6.5%). Inflation is rising at the fastest pace in China in more than 10 years. The culprit is almost entirely food costs, caused by supply constraints. The Chinese government is trying to contain the inflation with price controls.

Chinese consumer spending (retail sales +17.1% year over year) remains too hot and is not sustainable. Unless China can begin to rein in its growth and control inflation we could be looking at a major correction. Investing in only one country or region is risky. The investment inflows into Asian and Chinese oriented investment vehicles have been of tsunami proportions.

Is the Chinese market ready for a correction? Given the alarming growth of the iShares FTSE/Xinhua China 25 Index over the last three years, I wouldn't be surprised. It looks surprisingly like many historic investment bubbles such as the Nasdaq high tech/internet bubble and the more recent housing bubble. Will the Chinese stock market suffer the same fate as the NASDAQ or the housing market anytime soon? That is unclear, but a pullback sooner or later is inevitable.
I have not allocated a significant portion of international investments to emerging market mutual funds. Most international funds have over 5% invested in emerging markets. It is dangerous to then allocate another 10% to this sector given its inherent risk. I am firmly committed to increasing the allocation to international stocks and bonds in each client’s portfolio but not to over emphasize the emerging markets.

My goal is to structure each portfolio so that the overall equity allocation is equally-weighted between U.S. and international stocks. As we become a global economy this equally-weighted allocation just makes intuitive sense, but in the investment world this is a radical strategy. Most investment strategy is fashioned by looking at history (backwards) and frequently misses indicators that signal major shifts in the economic paradigm. The world is no longer U.S.-centric and this shift in growth is recognized in your portfolio allocation. If you decide to increase your international allocation, just make sure you do not overweight the risky emerging markets sector.