Emerging Markets: Testing times for emerging economies

While emerging markets have been the darling of investors in recent years, the love affair turned decidedly cold last year as they were spurned in favour of the perceived safety of more traditional assets such as US Treasuries.

It has been a dramatic fall from grace, with the MSCI Emerging Markets Index (which tracks 746 companies in developing nations), dropping 54 per cent in 2008, the worst annual performance since the creation of the index in 1987.

According to Bloomberg, Russia’s Micex dropped 67 per cent, while the Indian Sensitive Index 30 dropped 52 per cent, compared to a 42 per cent loss in the MSCI World Index and a 38.5 per cent drop in the S&P 500 Index.

Emerging market currencies have also been hammered, with the South Korean won down 40 per cent to the US dollar.

In response to the carnage, new data from the US-based research firm EPFR Global (which tracks fund flows and the asset allocation for over 15,000 managed funds), shows emerging market equity investors withdrew a record US$48.3 billion from funds in 2008.

Much of the drop in emerging markets has been attributed to the slowdown in developed markets, which has seen demand for oil, gas, metals and other resources slashed.

This led the MSCI BRIC Index, which covers the powerhouse economies of Brazil, Russia, India and China, to finish 2008 down 60 per cent.

Stimulating the markets

While the story for investors last year was grim, not everyone is gloomy, with some of the world’s top emerging market experts, such as Mark Mobius at Templeton Asset Management, now snapping up emerging market stocks.

In fact, the EPFR Global data noted losses to emerging market-managed funds had been pared back by US$1.6 billion late last year after a rebound in emerging market equity prices in November.

Much of this rebound and change in sentiment is being driven by the rapid cuts to global interest rates and the decision by governments in developed markets to introduce major stimulus packages.

Emerging market governments are also doing their bit, with China unveiling a US$586 billion package designed to keep its gross domestic product (GDP) growth above 8 per cent.

These developments have seen Mobius pull out the cheque book.

“We’re having a wonderful time buying tremendous bargains,” he said in a Bloomberg Television interview early in 2009.

Emerging markets will be major beneficiaries from the flood of money being pumped into the financial system by governments, Mobius said, arguing 2009 would be the start of the next bull phase for the sector. “This is due to the amount of money being pumped into the system. All this money needs to find a home somewhere.”

Principal Global Investors chief executive Grant Forster agrees the fiscal stimulus will have a significant impact.

“The next 12 months will be a time of a lot of liquidity and, generally, that is a good time for emerging markets.”

Mobius pointed out that since the first emerging market fund was established in 1987 there had been nine bull and bear periods, “so we are not too worried and are looking forward to 2009 with great optimism”.

It is a view shared by a number of other investment professionals.

A survey at the end of 2008 by global consulting firm Watson Wyatt found fund managers held generally bullish views about the likely returns from some emerging markets over the next five years.

Overall, the managers expected stock markets to revert to historical return levels by 2012, with the median anticipated return for Asian equities markets (ex-Japan) in 2009 predicted to be 10 per cent.

Divided views

But not everyone is so sure. Opinion remains divided about the prospects of emerging markets and even the future performance of individual BRIC economies.

As HSBC Bank Australia head of funds and investments Charles Genocchio noted, “There is definitely a divergence of views on emerging markets”.

Merrill Lynch’s US-based chief emerging markets equity strategist, Michael Hartnett, is among those remaining cautious.

In December he pointed out equity allocations to the sector had fallen to their lowest level since 2001.

“It would now be a major surprise for global fund managers if emerging markets were to outperform US equities in 2009.”

Hartnett said Merrill Lynch’s latest survey of investor sentiment indicated China remained the preferred choice of Asian equity investors and emerging market specialists, with a net 50 per cent saying they wanted to overweight Chinese equities, despite the fact most managers expect the Chinese economy to slow down this year.

“Ironically, the slowdown is indirectly making investors more bullish on China, thanks to the promise of policy stimulus and falling commodity prices,” he said.

There is also considerable caution about emerging markets because of the current geopolitical volatility and global economic uncertainty. In particular, the incoming US administration is seen as a key driver of market returns in the sector.

“It will be very important to see what the Obama administration comes out with, as it will have huge ramifications on emerging markets,” Genocchio noted.

If the new administration starts raising trade barriers to protect US jobs and the economy, the impact on emerging markets will be dramatic.

Genocchio said he is “hesitant” to invest in emerging markets in the first quarter of 2009 until the US picture is clearer, but he believes the fundamental value of emerging market investments remains intact.

“From a valuation perspective, emerging markets have never been more attractive,” Genocchio explained.

“They are oversold on all factors, but I am cautious due to the implications of the new US administration.”

Aberdeen Asset Management’s Singapore-based fund manager Asia-Pacific (ex-Japan), Andrew Gillan, is also cautious.

“This year will be tough for companies globally so, in the short term, emerging market prospects are not fantastic, but if you take a long-term perspective, valuations are looking attractive.”

He is a strong advocate of investors taking a long-term view.

“Emerging market risk is higher and volatility is higher relative to developed markets, but if you buy good companies with good balance sheets then usually they will do well.”

Death of decoupling

Much of the enthusiasm for emerging market investing was driven by the so-called ‘decoupling’ theory, which claimed emerging markets could continue growing despite the slowdown in developed markets.

The magazine The Economist was one of the exponents of this view, arguing in March 2008 that “recent data suggests decoupling is not myth. Indeed, it may yet save the world economy”.

However, the performance of emerging markets late last year seems to have firmly trashed this theory, Forster said.

“Emerging market debt held on to the fourth quarter and then finally gave way. It showed the fantasy — or illusion — about emerging markets decoupling was finally being put to bed,” he said.

“The capacity to self-generate growth from inter-regional trade is proving to be just not there.”

Even emerging market bull Mobius said he was “not a great believer in decoupling”.

The death of the decoupling theory is behind much of the current negativity about emerging markets, according to Genocchio.

Gillan agreed emerging markets were never going to be unaffected by the disasters occurring around the world.

“Emerging markets have not yet decoupled, as seen from last year and the impact of the US and European slowdown.”

Rather, he argued emerging market companies occupy different parts of the value chain to those in the West.

“It is a mistake to completely separate emerging markets from developed markets.”

While investors may be disappointed emerging markets have not ‘saved’ the world economy, professionals familiar with these markets believe a form of decoupling will slowly occur over time.

“I firmly believe in the concept of decoupling from an economic perspective, as emerging market growth in the next decade will clearly outstrip developed markets,” Genocchio explained.

“From an economic perspective, there is a strong case for growth in emerging markets compared to developed markets.”

According to Gillan, Aberdeen’s interest in emerging markets relates to the growing domestic demand from strong economic growth and a younger demographic in emerging market countries than in developed markets. “We like this, rather than the old view of thinking of emerging markets as exporters.”

Despite his scepticism about decoupling, Mobius believes emerging markets will still perform better than the developed market in the years ahead.

“We will see a reversion to emerging markets first as they are the cheapest and have the highest yields and best macro environments.”

From owing to owning

This view about the strong macro environment in emerging markets reflects the argument that there have been fundamental changes in these economies since previous bear markets, such as the one following the Asian financial crisis.

The experts point to governments in emerging markets working hard to develop stronger fiscal foundations, with many nations now being net creditors.

“Over the last decade, emerging markets have increasingly been pursuing sound fiscal policies,” Genocchio said.

To support this view, he cited figures showing the share of GDP to external debt in emerging markets over the past decade has dropped from 18 per cent of GDP to 6 per cent in 2008. “They have gone from being net debtors to creditors.”

In fact, it is the savings from several emerging market sovereign funds that have bailed out key Western financial institutions.

“Emerging market monetary policies have been very targeted to inflation, opening up foreign exchange and increasing market transparency,” Genocchio said.

While fund outflows from emerging market investments show a decline in investors’ risk appetite, Genocchio believes the shift into US dollars and US Treasuries is a “flight to perceived quality”, rather than a move to a true safe haven. “The debt being built up in the US is scary.”

The differences between the current market situation and the Asian financial crisis were also noted by Mobius.

“The weakness in the emerging market currencies is due to the rush into US Treasuries and the US dollar,” he said, pointing out that China and India were sitting on huge foreign reserves.

“I don’t think this is sustainable and we will see a reversion, particularly in those countries with strong foreign reserves and positive trade balances.”

Genocchio agreed this is an unusual situation and believes investors can make substantial gains from currency differentials.

“There are still great opportunities as the currencies are so weak.”

According to Gillan, the divergence in views over the prospects of emerging markets is tied to the emphasis on investment benchmarks, many of which do not properly capture the changed nature of markets in Asia or Latin America.

“Yes, there is a higher risk in emerging markets, but they can generate higher returns. Twenty years ago no-one bothered with China, India or the Russian markets, and if you look forward 20 years, no-one will dispute they will play a significant role.”

This longer timeframe means emerging markets need to be viewed as a long-term investment, Gillan said. “A minimum of three years and ideally five-plus years.”

Exciting prospects

Despite the current caution, emerging markets enthusiasts believe the fundamental case for this asset class remains in place and over the medium term it offers good prospects.

“The story is intact and we are positive about emerging markets,” Gillan said.

Part of this enthusiasm is the result of better growth prospects within emerging markets compared to the recession-bound developed markets.

For example, in November the International Monetary Fund predicted emerging and developing countries would expand by 5.1 per cent in 2009, compared with growth in the global economy of just 2.2 per cent.

Genocchio believes emerging market equities offer investors good long-term returns.

“Emerging markets are where the growth will be in the decade ahead.”

He pointed out returns over the past decade were seven to eight times that in developed markets, even with the 60 per cent drop in 2008.

Over the medium term, pricing is “extremely cheap versus developed markets”, Genocchio said.

“Emerging markets offer a huge amount of opportunities because markets have been sold off as much as they have. You can now buy emerging markets at a 36 per cent discount to the developed world due to the flight out of anything

perceived as risky.”

Gillan agreed with this view. “Valuations are now back to very attractive levels, although they have been lower in the past.

“The fundamentals are still intact in these markets and we believe they are on a quite solid footing.”

Emerging market allocations also offer valuable diversification benefits to investors, according to the experts.

“It is important to have diversified exposure and having some exposure to these markets is very compelling,” Gillan said.

“Emerging markets give Australian investors good diversification and exposure to higher growth markets … I think having no exposure to growth companies and markets is a mistake.”

Forster agreed, pointing out the diversification benefits are not simply in terms of geographic diversification but also sector diversification.

“Australia has a strong bias to the materials sector, so it is important to get exposure to other sectors.”

In terms of timing for investing, Gillan points out that when it comes to emerging markets, “historically their performance has been better when they are at a discount to valuations in developed markets”.