Mixed fortunes emerge in under-the-radar markets

The image of emerging markets as an investment sector has tended to be shaky with titles such as ‘The Fragile Five' describing some of the largest emerging market nations and their economies.

Up front it would appear those shaky impressions are well deserved with emerging markets struggling as the US economy rebounds and Europe finally attempts to regain the ground it has lost over the past few years.

Alliance Bernstein Portfolio Manager - Strategic Core Equities, Sammy Suzuki, said the ongoing uptick in the US economy has seen a shift in the fortunes of emerging markets, which had avoided the worst of the global financial crisis.

"There's definitely been a shift of interest from emerging markets back to the US and it's very visible in stock price movements. The US economy was the first to go into a downturn after the financial crisis and it's the first to come out, so the shift makes sense from that point of view," Suzuki said.

"The emerging markets by contrast are ‘last in, last out': they survived the global financial crisis (GFC) without a direct hit to their fundamentals and were relatively unscathed by the European debt crisis, but now it's their turn to face headwinds."

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Ibbotson Head of Multi-Asset Strategies Michael Coop said the shift to the US and other developed markets away from emerging markets was evident in terms of trade and capital and there had been strong trade growth in the US.

At the same time, capital, which has flowed towards emerging markets while interest rates were low, has reversed with sizeable outflows in the last 12 months according to Coop.

"These flows pumped up emerging markets and then pushed them back down and these markets have gone from high value to lower values," Coop said.

His view is shared by Van Eck global head of emerging market equities, David Semple, who added that it has not all been one-way traffic from emerging markets despite growth in the US.

"On one side, the higher return on growth in the US has helped attract capital from the rest of the world, including from emerging markets. On the other side, emerging market companies that have exposure to growth in the US, such as some IT companies in India and Russia, or manufacturers in Mexico, seem also to have benefited as a result of this growth," Semple said.

"We have been increasingly hearing from investors about the stretched valuations of the US stock market and increased volatility. The US has been witnessing some large outflows recently. However, those flows have not been directed to emerging markets. We believe that flows to emerging markets should pick up in the near future."

According to Semple this will be driven by the mechanism that has kick-started the US recovery and is being used in Europe to do the same — quantitative easing.

He said that while investment flows into emerging markets has been negative recently, quantitative easing has created a larger global liquidity pool at the same time as yields have fallen in developed markets.

"It is true that emerging markets cannot be viewed as homogenous but we should not remember developed markets as purer than emerging markets, particularly when they have engaged in the same behaviour." - Michael Coop

As a result some of this liquidity will be directed to emerging markets through direct investments in the financial markets or through loans to emerging market companies and institutions.

Suzuki said those emerging markets which have built growth off the back of capital inflows will find quantitative easing a mixed blessing in that what it gave it may also take away.

"There are meaningful emerging markets that have large current account deficits, so they rely on foreign capital inflows to sustain their growth, and the large amount of liquidity in the system has been positive for them.

"In terms of when the dollar was depreciating, that produced a more mixed outcome, depending on the country and the company concerned," Suzuki said.

"As liquidity tightens and yields in the US improve, however, the money will flow away from other parts of the world, back into the United States, and that could potentially be a negative at the margin for the weaker countries."

However those following this interplay between developed and emerging markets may find it hard to identify what behaviours align with each market given that during the past few years some developed markets have engaged in some unusual practices.

Semple said Greece is a live example of this emerging market behaviour from a developed market nation and that during the GFC a number of developed countries racked up significant debts and allowed high current account deficits.

"We can say that emerging markets behaved more like developed markets during and after the crisis than some developed countries themselves. China, which is considered an emerging market, was actually part of the solution as the crisis was unfolding by launching a stimulus program in 2009 to boost its economy," Semple said.

Suzuki agrees that the US exhibited some instability during the housing crisis as did Europe during the debt crisis but it is important to distinguish between behaviour and structure.

"When economic instability occurs in emerging markets, the response is to raise interest rates to prevent the flight of capital. That's what makes emerging markets enormously cyclical.

"But countries with a reserve currency don't have to do that, and that's often a benefit that developed markets have: when they run into problems they can actually loosen policy," Suzuki said.

Yet when it comes to the actual act of investing in emerging markets Coop believes the labels are less useful than in the past and may even be used derogatively to deride markets that fared better during the GFC than some developed markets.

"Long term investors look at time horizons and with equities that is usually five to 10 years. Emerging markets offer exposure, diversification and are attractively valued in such a way that they fulfil the long term role required to build wealth," Coop said.

"It is true that emerging markets cannot be viewed as homogenous but we should not remember developed markets as purer than emerging markets, particularly when they have engaged in the same behaviour.

"People have tended to remember the poor behaviours of emerging markets and the crises of the past but many emerging markets have shifted because of those events."

Kicking the tyres

If emerging markets have lost some of their lustre how should financial advisers approach them and what questions should be asked before allowing clients to invest?

Suzuki, warns against seeing emerging markets as a single market or single sector that can be dealt with in one movement. Instead investors and advisers need to be aware of some of the specific economic trends and events which are taking place in those markets.

"Within emerging markets, country effects are very significant. In assessing a country, a lot of people look at gross domestic product (GDP) growth — but GDP growth is actually not a good predictor of equity price movements. What matters much more in emerging markets is the perception of risk of that country," Suzuki said.

"What you're really looking for is whether the perceived riskiness, or governance, or the map of stability of a given country is rising or declining; combined with that, stock specifics are always important."

At this level of investing, stock selection needs to be actively managed and based on bottom up fundamentals, according to Semple, who said this approach will uncover opportunities or companies that represent structural growth in emerging markets.

"Often those companies are plugged into structural themes that are driving growth and are manifestations of the secular growth story in emerging markets. Some of the themes we have identified include internet and industrial sectors in China, education and health care in emerging markets, the banking sector in South America and the developing consumer story across most emerging markets," Semple said.

This type of approach is well removed from investing in the index with Franklin Templeton emerging markets group executive chair Mark Mobius stating planners, and their clients, should not underestimate the size and extent of the emerging market sector.

"It is important to remember that emerging market countries represent a large share of world economic activity and makes up approximately 30 per cent of the global market capitalisation of companies," Mobius said.

"The best way to invest for the long-term in emerging markets is by investment in a portfolio with a global emerging market exposure. This is crucial because it is actually possible to have all your eggs in the wrong basket at the wrong time. We think it's important to be diversified not only across different companies, but across different industries and, most importantly, across different countries.

"Unfortunately, many investors have portfolios that invest in only one country — their own. We see this as a big mistake because they are missing out on potential opportunities all over the globe."

Read part two of Jason Spits' report - Is China still an emerging market?