The slower economic growth prospects for both the U.S. and Europe have been prompting a growing number of investors to focus a larger share of the investment allocations to emerging markets where a healthier economic environment and sounder policies ensure that growth rates will remain above average for some time to come.
Whilst there is no denying the relative attractiveness of emerging markets at this particular point in time, there is the traditional tradeoff of greater volatility or risk in return for the expectations of higher returns.
There is, however, an additional risk factor that should not be overlooked. The price / earnings ratio (P/E) of developing markets tend to be higher than those of developed markets and right now the difference is rather important given the growing enthusiasm for emerging market investing. The graph above shows the difference in P/E ratios between the U.S. and China. Trouble with high and expanding P/E ratios is that it may be signaling bubble territory which means that there may be a real risk of a sharp correction sometime down the road.
Considering the degree of globalization and integration of economic markets across the globe, a more effective and less volatile way of investing into emerging markets may be through developed market stocks. Given their lower relative P/E ratios, longer history, corporate culture and growing exposure to emerging markets, a number of developed market firms may in fact provide a more effective manner of gaining exposure to emerging markets at a lower volatility to comparable firms in the region. Food for thought.
