New global hot spots for investors

December 16, 2011: 5:00 AM ET

As U.S. and European economies struggle, investors looking for healthy returns might consider emerging markets.

By Richard McGill Murphy, contributor

A construction worker on the 18th floor of a new hotel in Jakarta

A construction worker on the 18th floor of a new hotel in Jakarta

FORTUNE -- Today, essentially two global economies exist side by side. The U.S. and its advanced peers continue to struggle with high unemployment, idle capacity, depressed housing markets, and anemic growth. Credit remains tight in much of the developed world, despite historically low interest rates. Debt-laden European nations pose heightened risk for anyone exposed to their banking system. (See: Corzine, MF Global, Inglorious End of.)

By contrast, the global financial crisis has "left no lasting wounds" on China, India, Brazil, and other emerging economies, according to a recent IMF report. Emerging markets were for the most part in better shape than their advanced counterparts before the crisis, with less public debt, higher domestic savings rates, and stronger exports. In many developing-world capitals, policymakers worry more about their economies overheating than stalling out. Numbers tell the story: The IMF expects the world economy to grow at an annual rate of 4.5% this year and next. But advanced economies are likely to see annual growth of only 2.5%, vs. 6.5% for the developing world.

What does all this mean for investors? A new study by the McKinsey Global Institute suggests that emerging economies will be the place to invest over the next decade. Already the developing world is amassing financial assets at a much faster rate than are traditional banking centers like New York, London, and Tokyo. The total amount of global stocks, bonds, and loans increased by $11 trillion last year to $212 trillion (see chart below). However, the share in mature economies rose by only 3.9%, compared with 13.5% in the developing world, which of course grew from a far smaller base. While it is true that the rich world still commands some 79% of the world's financial assets, the emerging economies' share is expected to nearly double, from 21% today to as much as 36% by 2020.

One challenge: Local investors in emerging markets tend to put most of their money in bank accounts and fixed-income securities rather than in the stock market. Will companies be able to raise enough equity to keep growth humming? The bet is that emerging-markets investors eventually will warm to equities, assuming of course that Asian and Latin American exchanges can boost investor confidence by adopting stricter listing requirements. It already may be starting to happen. McKinsey reports that China is the new world leader in IPOs, with $125 billion raised last year. (The U.S., by contrast, raised only $35 billion.) Western companies like Glencore and Prada have recently listed shares on the Hong Kong exchange. And Coca-Cola (KO) is currently exploring a listing in Shanghai. For a picture of where the world of money is headed, read on.

CLICK ON THE MAP FOR THE FULL IMAGE

How volatile are emerging markets?

Any investor lucky enough to have survived the Asian financial crisis of '97 can't be blamed for a reluctance to invest in the developing world. In the flick of a key, money managers in New York and London pulled hot money out of heavily indebted Southeast Asia, bankrupting companies and ruining investors. Buying stocks and bonds in markets such as Brazil, Russia, India, and China remains risky for individual investors, especially in times of world economic turmoil. Yet from a macroeconomic point of view, a new McKinsey study controversially argues that capital flows into emerging markets now are less volatile than flows into advanced economies (see chart below). Why? Emerging markets attract a higher percentage of foreign direct investment (FDI). Global investors buying stakes in durable assets like factories and mines now account for a larger proportion of capital flows into emerging markets than cross-border lending and stock and bond purchases. In the developed world, by contrast, international capital flows are weighted toward cross-border bank lending, which is up to four times more volatile than FDI, according to McKinsey. Just recall what happened during the last financial crisis. For the individual investor, growth in FDI represents a vote of confidence in a local economy. Here's where big bets are being placed:

Searching the globe for high yields

In coming years bond investors might well find the best returns in emerging debt markets -- albeit not without some risk. Why? Opportunities to tap into the growth of both new and established companies will abound. The total value of corporate bonds and securitized assets amounts to 7% of GDP in emerging markets, compared with 34% in Europe and 108% in the U.S., according to the McKinsey Global Institute. Corporations in the developing world will need to borrow to keep building airports, railroads, and factories.

The risk, of course, is that many of these companies operate under liberal accounting rules -- to put it mildly -- and do business in nations that are politically unstable. In China experts fear a debt bubble. Companies there have been on a building spree, borrowing money to build office and residential towers, steel mills, and car factories. A slowdown in the Chinese economy could make this debt bubble burst. That said, cautious and patient investors looking for a higher fixed-income return than can currently be found by investing in corporate bonds in the U.S., Europe, and Japan might tap into the more vital growth of the world's emerging markets.

More Fortune Investor's Guide 2012

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Ramit Sethi: The new finance guru on the block

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The best and worst of Wall Street 2011

Being a boring investor ... and loving it

Can Wall Street thrive again?

This article is from the December 26, 2011 issue of Fortune.


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