Investors were caught off guard by the emerging market commodities, currency and exchange traded fund (ETF) sell-off in response to the Federal Reserve’s late January announcement that the central bank would continue its tapering program.

The Fed said that it would reduce its bond buying program by another $10 billion to arrive at $65 billion in February, and the reaction in emerging markets was swift and severe.

The sell-off represents a once-in-a-lifetime opportunity to purchase inflation protection at ultra low prices that we may not see in another generation. This is mainly because the market has significantly overreacted, with uncanny similarity to last May, when a sell-off was triggered after Fed Chairman Ben Bernanke made his initial comments about plans to taper the stimulus program.

Then as now, overseas market selloffs were prompted by investors buoyed by optimistic views about US economic growth and higher rates. Investors previously had been forced to seek higher risk yields overseas as a result of Fed stimulus that kept Treasury rates and investment returns low. Investors could be forgiven for believing they would find the same high yielding, though safer investments in the US, because the winding down of the central bank’s stimulus effort implies greater growth and investment opportunities in America.

Except that the emerging markets calculus is not as cut-and-dried as the previous rationale would have you believe. The world has indeed changed since the 2008 global financial crisis, and emerging market growth rates are projected to be higher than developed economies for some time in the future, even as certain overseas economies have slowed down (see chart below). Emerging economies as a whole also enjoy lower debt levels.

Investors Ignore the Global Growth Divide at their Peril



Source: International Monetary Fund (IMF)

The reason the emerging market sell-off can be regarded as an overreaction is that until the Fed rolls back its stimulus program fully, investors can’t know if the US economy has really turned the corner. In fact, before January’s taper increase, some speculated that the Fed might reverse itself and increase stimulus because recent job reports had been weak.

Apart from the taper, we know that the Federal Reserve won’t raise short-term interest rates, now pinned near zero, until the jobless rate goes below 6.5 percent and as long as expected inflation does not breach 2.5 percent. Consequently, there’s an upper limit as to how high rates can go in the near term.

Even as some have regarded last year’s fourth quarter 2013 gross domestic product (GDP) growth of 3.2 percent as evidentiary that the US economy has turned the corner, when looking at overall growth, the picture is not as rosy. The fourth quarter 2013 GDP growth rate of 3.2 percent was down from the 4.1 percent rate logged in the previous quarter.

Moreover, in 2013, GDP growth was a tepid 1.9 percent, down from a 2.8 percent rate in 2012. For 2014, the International Monetary Fund (IMF) revised its forecast of US GDP growth to hit 2.8 percent, which would be flat with 2012. The US economy has not posted a 3 percent GDP growth figure since 2005.

These growth numbers are in contrast with various emerging economies in Latin America and Asia that are expected to grow at between 5 percent and 7 percent, which makes the sell-off all the more surprising as investors appear to be shunning higher growth investments and the advantages of diversification.

Meanwhile, the volatility in emerging markets from these sell-offs doesn’t have many emerging markets experts all that concerned that this will permanently damage most of these economies (although to be sure countries such as India, Turkey and South Africa are being watched closely, as their economies are in weaker states).

The reason there is less concern about emerging markets as a whole is that most emerging markets economies have stronger finances and more ample reserves now than after the Tequila Crisis, which began with a Mexican devaluation in 1994, or the Asian Contagion, which was touched off in 1997 by a devaluation of the Thai baht.

Even if the emerging markets’ instability worsens, it may have a silver lining for advanced economies by adding to the downward pressure on global commodity prices. As such, natural inflation hedges such as commodities and emerging markets ETFs, now at all time lows, present an incredible buying opportunity.

Considering the present state of various commodity indexes, bond and ETF indexes, these markets are at multi-year lows, which suggests this would be an opportune time to purchase them, because they afford investors the best chance of both preserving wealth and enhancing wealth, if held before an extended inflationary period (see chart below).

Emerging Markets ETFs, Commodities, and Bonds: Historical Discounts



Created with Y Charts

The iShares Core MSCI Emerging Markets ETF (NYSE Arca: IEMG) is down 12 percent over the last year. But with powerhouse companies in its core holdings, such as South Korea’s Samsung Electronics (OTC: SSNLF), Russia’s Gazprom (OTC: OGZPY), China’s Lenovo (OTC: LNVGY), and Mexico’s America Movil (NYSE: AMX), it stands to reason this index will be back on top when investors return in droves to emerging markets. The iShares Core MSCI Emerging Markets ETF is a buy up to 50.

With developed economies’ GDP growth starting to improve, it’s hard to believe that the commodity heavy iShares MSCI Emerging Markets Latin America (NYSE Arca: EEML) will not improve with it. Latin America has been buoyed over the last few years by heavy commodity demands from Asia and around the world, a demand that should accelerate this year. The iShares MSCI Emerging Markets Latin America is a buy up to 45.

The iShares JPMorgan USD Emerging Markets Bond Index (NYSE Arca: EMB) has finished with a loss in four years prior to 2013: 1994 (-18.9 percent), 1998 (-14.4 percent), 2001 (-0.8 percent), and 2008 (-9.7 percent). Each time, the index rebounded to close with a robust gain in the following year: 26.8 percent (1995), 26.0 percent (1999), 14.2 percent (2002), and 26.0 percent (2009).

Moreover, when looking at specific regions, most bets are that Asian high yield bonds will perform admirably this year. But within the region, most analysts agree that Australia will make a superior fixed income investment over Japan and China, though all three countries are expected to benefit from a global uplift in trade in 2014.

According to a Russell Investments research note, “In stark contrast to the strong performance of Japanese equities in 2013, that country’s government bonds have yet to respond at all. They’ve shrugged off the combination of stimulatory monetary and fiscal policies, a weak yen, and a return to strong GDP growth to do…nothing. They remain the outlier of the developed world, with the 10-year rate, in mid-December 2013, trading at a skinny 0.7 percent. If our expectations are correct, and 2014 sees a second year of meaningful recovery in Japanese growth and inflation, then rates can move higher, notwithstanding the ‘anchor’ of a 0.1 percent cash rate.”

But at present all eyes are on Australia, according to the Russell Investment research note, where 10-year government bonds are trading at 4.4 percent as of December 6, 2013, and where growth rates are beginning to lag northern hemisphere counterparts for the first time in a decade.

“Weaker economic growth would be a positive for Australian bonds. On the other hand, foreign holdings of Australian debt rose to record highs through the years of global crisis. As Australia’s ‘safe haven’ status fades, there is some risk of a rush for the exits. Hedging costs are also high, and we regard the Australian dollar as overpriced,” according to the research note.

Moreover, in general emerging markets’ corporate and local currency bonds should be the focus, because they offer higher yields, which provides them with a more favorable starting point for total return, and excellent diversification. Corporate issuers as a group are in robust financial health, and with much better credit ratings than bonds with similar yields issued by companies in the United States, according to various credit rating agency reports.

We advocate a portfolio balanced between equities and fixed income—and global fixed-income investments will take on greater importance in 2014.

As noted above, iShares JPMorgan USD Emerging Markets Bond Index is best positioned to offer protection, diversification and income growth in what is still a very uncertain environment with respect to growth projections throughout various developed economies in 2014. The iShares JPMorgan USD Emerging Markets Bond Index is a buy up to 110.

So far, the growth of the monetary base has not filtered through to overly rapid growth in the broad monetary aggregate, “M2” money supply, which is growing moderately at a 4.1 percent annualized rate so far this year. Nevertheless, the rapid and unprecedented expansion of the monetary base has alarmed the world’s reserve managers, who fear that the value of their dollars may be eroded by renewed inflation.

It is important to note that other countries, notably Japan and the United Kingdom, have embarked on quantitative easing programs of similar magnitude to that of the US to combat or avoid deflation in their own economies and to deliberately weaken their currencies.

With respect to inflation protected bonds, we believe the SPDR DB International Government Inflation-Protected Bond (NYSE: WIP) offers greater protection than TIPS, though TIPS inflation protection should be a part of every portfolio.

Founded in 2008, WIP is an ETF that seeks to provide investment results that correspond generally to the price and yield performance of the DB Global Government ex-US Inflation-Linked Bond Capped Index (DBLNDILS).

The ETF holds specific types of foreign sovereign bonds that are linked or indexed to an inflation calculation in another country, similar to how TIPS in the US are indexed to the Bureau of Labor Statistics’ CPI.

To be included in the Index, bonds must: 1) be capital-indexed and linked to an eligible inflation index; 2) have at least one year remaining to maturity at the Index rebalancing date; 3) have a fixed, step-up or zero notional coupon; and 4) settle on or before the Index rebalancing date. As of July 30, 2013, the ETF recorded a net asset value (NAV) of $1.16 billion and a low expense ratio of 0.50 percent.

SPDR DB International Government Inflation-Protected Bond pays out a monthly distribution that amounts to an annual yield of around 3.76 percent. Its holdings are linked to inflation measures in countries outside the US. The high yield may signal that inflation is beginning to increase in countries where this ETF holds bonds.

The fund’s holdings include government debt from more than 15 countries, including Chile, the UK, Sweden, Israel, Italy, France, Japan, Poland and South Africa. The fund is actively traded and its holdings can change very rapidly and drastically within only a few weeks. The fund’s largest bond allocations are in Chile (over 65 percent), the UK (over 6.5 percent) and France (over 6 percent).

More than 70 percent of the fund’s held debt is rated as AAA+ or AAA by ratings agencies such as Moody’s, S&P and Fitch. Nearly 64 percent of the fund’s debt matures in less than 1 year. And less than 15 percent of the debt held by the fund is long-term debt that matures in 10 years or longer. The SPDR DB International Government Inflation-Protected Bond is a buy up to 65.