from the February 2006 issue

Israel: an Emerging Market Opportunity

Emerging-market equities are continuing their strong run. After outperforming developed markets for four years, in 2005 emerging European equities were up by 42%, and Latin America was up by 22%, while Asia has gained a more modest 15%.

The strong performance is all the more impressive given that US interest rates and the dollar have been rising while expectations for global growth have been slowing for most of 2005. In the past, riskier assets have typically under-performed in such conditions.

We have identified several risks which could weigh on emerging markets' performance in 2006. If US growth slows more than we expect, that would be extremely negative for emerging markets. Any slowdown in the Chinese economy would also be a major problem - whether it was caused by decelerating US growth or by Chinese policy-makers taking steps to moderate non-bank credit growth.

Another risk is rising domestic interest rates and falling current-account surpluses. Both threaten to drain liquidity from emerging markets, especially in Asia. Political risks are also likely to re-emerge as a factor in 2006 - with several elections scheduled across Latin America and Eastern Europe.

The large number of risks suggests that emerging markets will see higher volatility in 2006 and may struggle to outpace developed markets.

Having said that, it should be pointed out that valuation levels are extremely strong for the emerging markets asset class and even more so for active, risk-controlled emerging markets portfolios, which have a single-digit price-to-earnings ratio, with attractive earnings growth forecasts. Overall, compared to other asset classes, the emerging markets are the most attractively valued equities available to investors.

In addition, from a timing perspective, the emerging markets asset class is selling at historically low valuation levels as compared to similar assets in developed markets. Based on price-to-earnings ratios, for example, valuations are currently half of those of developed markets, compared to an average of 0.75 over the past fifteen years. It is hard to imagine that such compellingly strong fundamental value can long be ignored.

Finally, the fundamental case for emerging markets investment remains sound. The two decades since these countries first made forays into the capital markets are only a short period in world economic development. Yet during this period emerging markets have come a long way in establishing sound fiscal and monetary policies, restructuring their economies, addressing corporate governance, and improving their economic fundamentals. Keeping this in mind, the potential for continued rapid, positive change in these economies and markets is still very strong.

Long-term fundamental positives for the emerging markets include:
Large, rapidly industrializing populations
Undervalued currencies
Declining current account deficits
Improving infrastructures
Competitive wages
Increased competition, reform and restructuring
High savings rates
Long-term propensity toward growth

Israel is a par excellence example an attractive emerging market. The crippling stroke suffered by Prime Minister Ariel Sharon has had no obvious long-term effect on stock markets in the region, despite the fresh political unknowns emerging from his anticipated departure from public life.

Israeli shares fell more than 6 percent on Jan. 5 after Sharon underwent surgery, but they quickly recovered, and since the start of the year the market is up by single digit percent. The Arab stock markets, in Egypt, Morocco and Jordan, all show strong gains for the new year, as much as 16%. Sharon's rapidly deteriorating health heightens political uncertainty in the midst of an election cycle and introduces new risks and challenges for the economy and financial markets.

Israeli shares rose about 29 % in the past year, a restrained performance by recent parameters in this part of the world. Egyptian stocks have risen as much as 144 percent in the same period. The markets are capable of further upward movement, according to Middle East watchers.

We think investors should look past the current market anxiety and make a careful and objective appraisal of the present opportunities in the emerging markets. We believe this asset class will serve investors extremely well in the long term, and that the current valuations and outlook justify an increase now in emerging markets allocations for global fund sponsors. The current uncertainty, while uncomfortable in the near term, provides a classic long-term buying opportunity.

Reprinted from the Israel High-Tech & Investment Report February 2006

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