Emerging markets: alternative investment markets

China leads the field when it comes to emerging markets, but there are some attractive alternatives in the sector. Benjamin Levy reports.

The Asian emerging markets are the most popular kids on the block right now — China in particular.

Not only were they credited with saving the world from a depression with their powerhouse economies, but their truckloads of available capital and high personal savings rates are drawing every financial planner and investment house like a magnet.

Despite their comparable economic growth, other emerging markets like Russia and Eastern Europe are almost ignored — given only a perfunctory glance by most financial planners and investors.

But Asia’s popularity, and that of the other emerging markets, hasn’t come without some pain.

The sector was hammered in the global financial crisis (GFC) thanks to a perception of being riskier and more problematic than the developed world, a perception that persists despite concerted efforts by the funds management industry to change it.

Convincing investors to stay in the market for the long term is also proving a hard sell, with most following an established trend of shorting the market — despite the very real prospect of recording a loss.

Going where the money is

While fund managers try to flog non-Asian countries as an opportunity for Australian investors, financial planners are more interested in China and its healthy balance sheets.

The high level of savings in the Southeast Asian economies and comparatively low levels of government debt are pulling financial planners and investors to those markets above all others.

“Most of our emerging markets exposure is in Southeast Asia, which has more developed and more sophisticated markets and a cultural [trend] to save money, which isn’t as strong in countries like Brazil and Eastern Europe,” says Neil Kendall, managing director of boutique planning firm Tupicoffs.

Standard and Poor’s (S&P) was an early prophet of the trend. An emerging markets sector review in March 2009 suggested that the Asian emerging economies, particularly China with its “solid fiscal position” and better fundamentals, might be of more value to investors than places such as Eastern Europe.

“In the emerging economies of Eastern Europe at the moment, a crisis is brewing in the financial services and banking sector,” says S&P Fund Services analyst Leanne Cook.

One of the legacies of the GFC is a capital shortage in the developed markets of the United States (US) and Europe, thanks to their high levels of public debt and an all-consuming focus on cutting spending, raising taxes, and other austerity measures.

Such a focus can only drive investors and planners towards places like China, South Korea, Hong Kong, Taiwan, and Thailand with their comparatively low levels of government, corporate and private debt.

“In emerging markets, the consumer is relatively cash rich. They have high savings levels so they can continue to consume, corporates are cash rich so they can continue to expand and grow, and governments are cash rich so they don’t have to put up taxes and cut spending,” says Aberdeen senior investment specialist for offshore funds, Stuart James.

Countries in Southeast Asia have always had high levels of savings among their citizens, but pre-GFC, when capital was freely available in the developed markets, Asian money was just one source among many.

Now that the GFC has caused capital in the developed world to dry up, that investment resource has become far more valuable and the financial services industry is fighting hard for it.

Tupicoffs recently completed a round of recommendations to all its clients to increase their exposure to Asian emerging markets.

“One of the things that we think came out of the financial crisis is that there is now a global scarcity of capital. In our view, countries and companies that are capital intensive, or capital hungry, won’t do as well as those who have a savings culture, and that’s your Asian economies,” Kendall says.

The savings culture in Asia is even more important to investors than the strong consumer demand present in other emerging market economies such as Brazil, Kendall says.

Australia’s major banks are racing to exploit this happy circumstance. ANZ completed its acquisition of ABN Amro’s private banking business in Taiwan in April last year, before being granted regulatory approval by China in September to begin lending and banking operations in the country.

The gut instinct of Australia’s financial services industry to invest in China-associated companies was borne out by S&P research in July last year.

That analysis showed that three median managers with emerging market China funds outperformed their benchmarks over one and three year periods, compared to other fund managers in Global Emerging Markets and Asia ex-Japan who underperformed.

Global equities managers have also seen the light, with Lonsec pointing to an 18 month trend of traditional global equities managers increasing their exposure to Asian developing economies through either increased direct allocations or firms that have significant operations in those markets.

“Asia has emerged from the recession with the strongest ‘buy’ signal of any region,” according to the review.

That move is also developing opportunities for investors to gain exposure through newer, more country-specific emerging market specialists, or through the global emerging market funds that formerly dominated the field.

Promoting other countries

This focus on China and Asia has left other emerging market fund managers high and dry.

Between 1999 and 2008 Russia and Eastern Europe was the best performing region in stock markets throughout the world, according to Michael Hanson-Lawson, head of the Hong Kong office at Eastern Europe asset manager East Capital.

East Capital’s Russian fund, launched in May 1998, rose more than 2000 per cent in value in just a year. But the Chinese economic juggernaut has commanded all the attention.

Although the Russian index rose 115 per cent in 2009, its success has been overshadowed by China and India, and to a lesser extent, Brazil, Hanson-Lawson says.

Eastern Europe is underweight in most emerging market portfolios in Australia due to a mistaken perception that Asian emerging markets have better growth rates.

But a look at some of the growth figures in incomes and GDP for other emerging markets demonstrates how many opportunities are being ignored by investors in favour of China — and Asia in general.

Russia’s GDP per capita was approximately $10,000 at the end of 2010 according to the International Monetary Fund, forecast to rise to $16,500 by 2014. By that stage an average Russia consumer will have 2.5 times spending money than the average Chinese consumer, and 10 times the average Indian consumer.

Russia also has a very small amount of debt per capita, slightly more than one month of an average salary, giving consumers a large amount of buying power.

That buying power made Russia the largest retail market in Europe in 2007, including for expensive retail items like cars. While that market shrunk in the advent of the GFC, East Capital is confident Russia will soon regain that mantle.

“This is where we feel the domestic demand story is if anything more interesting in Eastern Europe and Russia than in other places,” Hanson-Lawson says.

Growth in Russia and Eastern Europe followed a trajectory of 4 to 5 per cent in 2010, a trend that Hanson-Lawson thinks is sustainable for years to come.

“This year we are back to a growth story, but again, it’s being overshadowed by the other emerging market countries,” he says.

China’s symbiotic relationship with its bordering countries is well known. Computer parts and other technology components are outsourced from countries like Taiwan and South Korea, allowing investors to take advantage of the region’s growth by investing in companies around Asia that export to China.

The same situation exists in Eastern Europe, but investors here seem to be unaware of it.

Germany retains a large manufacturing sector and frequently outsources the production of car parts to countries like Slovakia. Poland also benefits, drawing in direct foreign investment from Western Europe as a result of its flexible, well-educated (yet low-wage) work force.

Hanson-Lawson is hoping for a sudden opening of investor’s eyes when it comes to valuations and opportunities in Russia and the surrounding states.

Russia is trading on 6.5 times valuation earnings, only half the size of valuations in China and one-third the size of valuations in India, he says.

Despite convincing numbers, most investors and planners aren’t interested.

Centric Wealth uses some active managers for its exposure to emerging markets, but also relies on the ASX iShares MSCI Emerging Markets Fund (an ETF). Of 22 countries with a 0.1 per cent exposure or higher in the fund, nine are in wider Asia, six are in the Americas, and four in Africa, the Middle East, and Central Europe.

Three are from Eastern Europe. Wider Asia represents 57 per cent of the fund’s allocation by country.

The make-up of the fund is a clear indication of where the financial services industry’s priorities lie.

That hasn’t stopped some fund managers trying to drum up interest in ‘frontier markets’, which some think are the next destination for investors. HSBC Global Asset Management has been pointing to growth possibilities in places such as Libya.

In an address to an Australian Institute of Superannuation Trustees conference in 2010, HSBC global head of emerging markets Nick Timberlake said there were even greater possibilities in frontier economies than emerging markets.

Centric chairman of portfolio construction and asset allocation committee Ashley Owen admitted that his company wasn’t interested in frontier market exposure.

Frontier markets like Ukraine, Kenya and Bangladesh were up by 100 per cent in value over the last year, but they are so small they can’t make it into an emerging markets fund, Owen says.

“There’s about a dozen of them that aren’t on the charts, doubling in size every year or two, but they only have half a dozen stocks, and that’s made up of casino money and funny money, and there’s a lot of fraud and corruption.”

Getting into each country that is labelled a frontier market is proving too hard, Owen says.

Impact of the GFC on Asia

Emerging markets are subject to the whims of capricious investors. Their current enormous popularity makes it easy to forget that the sector suffered terribly during the GFC.

The MSCI Emerging Markets Index returned -57.24 per cent in February 2009, compared to -48.41 per cent for the MSCI World Index. The MSCI BRIC Index (Brazil, Russia, India and China) did even worse, returning -59.87 per cent.

Russia and Eastern Europe were the hardest hit of all the emerging markets, with an especially tough fourth quarter in 2008, according to Hanson-Lawson.

But while the developed economies suffered because of structural flaws and over-gearing, the emerging markets were playing the fall guy.

Many investors, shocked by the extent of the GFC, sold off their well performing and profitable emerging market stocks to balance their losses elsewhere.

Through that action, the emerging markets acquired a reputation for being flawed — which isn’t a true reflection of their long-term value for investors. Fund managers are still struggling against it.

“The financial crisis was an aberration, because although people were losing money in developed markets, they had to pull their money from somewhere to cover their position, and the BRICs [Brazil, Russia, India and China] had outperformed everything else,” says chief executive of Think Global Consulting David Thomas.

Emerging markets also suffer from a perception of being riskier assets than shares in the mature economies, contributing to the massive sell-offs that caused such high losses.

Aberdeen senior investment specialist for offshore funds Stuart James disagrees with the perception, especially considering that the problems originated in the developed markets.

“Generally, when you’re investing offshore, you bring into play things like foreign currency risk, and emerging markets are perceived to be riskier in terms of corporate governance, and in terms of government policy. I don’t think that is necessarily the case.”

However, the views of the major Australian research houses carry a lot of weight, and Morningstar was warning investors in late 2009 about the “explosive nature” of emerging market funds.

The Morningstar report labelled emerging market funds as among the most volatile offerings in the past decade, prone to sharp declines in less favourable environments, and at risk of government intervention and under-developed legal systems.

Such alarmist research views can only encourage investors to pull their money out of the sector at the first sign of trouble.

There is already a strong culture among retail investors to short the emerging market in the belief that they can time its highs and lows. They are copying the practices of institutional investors, but without the same capabilities, and it is damaging their chances of making real returns.

“Retail investors haven’t got the ability to time the market, it’s just too hard unless you’re living there,” Thomas says.

China, which is full of short-term investors, is a perfect example.

“If you believe in China’s economic story, then you have to take a long term view, because there are going to be months and even a year when you are going to have negative returns,” Thomas says.

Owen labels the short-term money flowing in and out of the emerging market as “hot money”.

“Hot money searches the world globally every night looking for a home, and at the first sign of a hiccup somewhere, the hot money is pulled out and the market collapses,” he says.

The problem typically leads to inflated asset prices and bubbles in the emerging markets, which collapse quickly and suddenly. The end result is a share market that is in a constant state of flux.

Many of the emerging markets are attempting to stabilise share market prices by regulating the flows of hot money.

Brazil has raised its capital taxes three times in the last eighteen months, while Chile recently announced it will introduce capital controls. Korea and Taiwan have also imposed controls, and Hong Kong is following.

“Those measures will probably not do enough,” Owen says.

Tupicoffs is trying to convince its clients of the merits of a long-term strategy.

“The way we position it to clients is that we are actively reducing our exposure to the United States internationally to replace it with emerging markets exposure internationally,” Kendall says.

But financial planners are coming under criticism for a prevailing tendency to simply buy a basket of emerging market exposures and “hope that their value increases”, Kendall says.

The tactic is a symptom of not knowing enough about the different emerging markets and their characteristics to invest properly in the sector, Thomas says.

In contrast, Australia portfolios are highly micro-managed, with detailed knowledge of different sectors, shares and their allocation and the way in which investments are selected, he adds.

One of the mistakes that investors and financial planners are making as a result of their lack of knowledge is thinking that strong economic growth will translate to a strong share market.

In China, the economy has been growing at roughly 8.5 per cent a year for 40 years, but their share market has been “all over the place”, whereas the Indian share market is more strongly connected to India’s economic growth, Thomas says.

The two different situations require different methods.

Some dealer groups like Centric are taking note, however.

“Markets like China look good on paper, but I’d rather be in companies in Taiwan and Korea and Singapore than in China itself,” Owen says.

Aberdeen’s Asian operations have expended lots of energy warning investors about this problem. Managing director for Aberdeen in Asia, Hugh Young, warned planners and investors at an investment lunch in Melbourne last year that buying Chinese shares because of strong Chinese economic growth was a “dramatically wrong decision”.

“It is indeed China where you can see economic growth, which has been tremendous, but the stock markets since they started have been pretty poor,” he said.

Structural problems

Government corruption and structural problems in China and other countries remain serious concerns for the planning industry.

A lack of corporate governance makes it necessary to be able to move quickly out of an emerging market if there are any hiccups, which is at least partly why Centric relies on the broad exposure of the ASX Emerging markets fund.

“ETFs are good in that way because you can simply change your allocation within a day,” Owen says.

The listed sharemarkets in emerging countries, particularly China and Russia, are largely dominated by a political agenda, with the board members of every listed company directed by the central government.

Much of the money being directed in China is ‘funny money’, Owen believes. Investments are directed by the government towards government-controlled lending facilities, which are then sent to local governments on the ground, which spend money ‘on bridges to nowhere’.

At each step of the way, the numbers are manipulated and inflated to sound more impressive, Owen says.

“I don’t believe a single number that comes out of China, and never have,” he says.

The comments make it clear that Morningstar isn’t the only player in the industry that steps warily in emerging markets territory.

But investors and planners should not be so quick to tar emerging markets with the corporate governance brush.

Fund managers are fond of pointing out that corporate governance issues exist even in the developed world, and that teething problems with newer immature markets are to be expected.

Babcock and Brown, Enron, ABC Learning Australia, Centro, and dairy company Parmalat are just some of the massive corporate governance failures in developed markets prior to and during the GFC.

“Good companies exist everywhere, and equally, bad companies also exist everywhere,” James says.

“They’re not any worse than their developed market peers,” he adds.

The strength of domestic demand in emerging markets is enough to outweigh concerns of corporate governance for some.

“In an emerging market there’s always risks. There’s scandals, corruption, problems associated with markets that are fairly immature and are only starting to be played by the big boys. But in my view, the reason that they offer stronger fundamentals than the developed world are because of the threads of domestic consumption,” Thomas says.