Ringing in a Prosperous New Year

As we’ve written on several occasions and as anyone who has invested in the emerging markets knows, this has been an extremely tough year, with the iShares MSCI Emerging Markets Index (NYSE: EEM) down by 8.1 percent year-to-date while the S&P 500 is up by more than 28 percent.

Playing a huge role in the emerging markets underperformance are several structural factors, including rising wages, falling current account balances and higher exchange rates.

According to data from the International Monetary Fund (IMF), the current account surplus in the emerging markets has fallen from a high of nearly 5 percent of gross domestic product (GDP) in 2007 to just more than one percent today.

In 2009, the developed world ran a current account deficit of more than 1 percent of gross domestic product (GDP)—now it’s at just basis points. Analysts forecast that the growth gap between the emerging and developed worlds will be less than 1 percent by 2018.

As the global economy becomes more balanced over the next few years, many emerging market giants such as China and Brazil will continue losing their competitive edge in terms of manufacturing and exports. At the same time, the developed world is regaining its advantage of years past, especially in the US where fracking and other advances are leading to cheaper energy.

That’s causing a significant shift in trade patterns, with exports from the US, Japan and Germany increasing in the five-year period between 2008 and 2012 versus the five years between 2003 and 2007.

Between those same time periods, exports from the emerging markets have actually declined slightly according to research from UBS Global Asset Management, showing that the developed world is becoming more dependent on exports to the emerging markets while the emerging markets are less dependent on exports generally.

Given those shifting dependencies, it&rs! quo;s inevitable that growth in the developing world will slow relative to years past. However, based on forecasts from the IMF, the World Bank and the major investment banks around the world, the developing world will continue to grow faster than the more advanced Western economies. The change lies in the fact that most of the growth is coming from increased consumption than increased investment.

China is an excellent point in case.

In the early 1980s, total investment as a percentage of GDP ran in excess of 50 percent and was still high at 48.4 percent in 2012. At the same time, consumption as a share of GDP ran at just 36 percent in 2012, well below the world average of 60 percent.

But between 2008 and 2012, Chinese consumption grew by more than 9 percent annually, while India’s grew by 7 percent and Brazil’s by less than 5 percent, according to World Bank data. In the developed world, consumption grew by a much slower 1 percent.

What it All Means for Investors

How does all of this affect the investment outlook for 2014?

For one thing, it doesn’t justify abandoning the emerging markets altogether. Rather, it calls for your focus to remain on consumer-oriented companies.

In years past, exporters and infrastructure plays have typically been the big winners, as account balance differentials helped make cheap financing available for major projects. But as healthy economic fundamentals have led to the strengthening of many emerging market currencies, weaker economies are finding it increasingly difficult to attract the same levels of foreign investment that have driven their growth in years past.

That challenge is only being exacerbated by the US Federal Reserve’s program of tapering its quantitative easing (QE). The situation will become increasingly challenging if the Fed conforms to expectations and ends its QE program by the end of next year.

That’s creating a bifurcation in emerging market performance for the! first ti! me in several years, as economic growth alone is no longer enough to attract foreign investors. As increasingly attractive opportunities can be found closer to home, the less need to take on the added risk of unhealthy economic fundamentals.

So 2014 should be a good year for countries such as Mexico, which has taken steps to liberalize foreign investment in its energy sector, shake up its educational system to encourage better outcomes and generally make its economy more business friendly.

The Philippines has also become increasingly attractive, as President Benigno Aquino has combated governmental corruption and pushed the country’s Congress to pass a series of measures to streamline the tax system, implement a program of land reform and address high transportation costs.

Other countries such as India and Brazil, where inflation and inefficient government policies have created serious growth challenges, will likely remain troubled in 2014 as they have difficulty attracting the high levels of capital they need to maintain growth.

In the stronger emerging markets, consumer-oriented companies will be the best bets as continued growth continues to swell the ranks of the middle class.

McKinsey & Company estimated that the emerging market middle class currently encompasses almost 2 billion people who are spending nearly $7 trillion annually. It also estimates that by the end of this decade, this middle class spending will increase to $20 trillion, nearly twice the current consumption in the US.

The narrowing imbalances between the developed and emerging worlds also means that countries such as Germany, the United Kingdom and even the United States should also continue to receive a fair weighting in your portfolio.

For instance, we wouldn’t be surprised to see US equities return another 6 percent or so overall next year, as the economy continues to show gradual improvement with particularly attractive gains in the energy and health care sectors.! Relative! ly low energy costs, as well as the structural reforms in health care as the key provisions of the Patient Protection and Affordable Care Act come into play, should continue to drive growth in the two sectors.

So while 2014 probably won’t be as positive as 2013, there are still significant potential gains ahead.

Europe also is poised to swing back to growth as its recession eases, with cyclical plays the best likely performers.

Many challenges lie ahead, such as continued high unemployment in the US, slower Chinese economic growth thanks to its economic rebalancing and the lingering effects of the European debt crisis. Nonetheless, we face a prosperous New Year, as long we continue to focus on quality.