A force to be reckoned with emerges

Stuart James

Last year was another strong year for emerging market equities, with aggregate gains exceeding 30 per cent in US dollar terms, led by China, Venezuela and Indonesia, which rose more than 70 per cent each.

The rise in share prices, which helped many markets hit fresh records, was backed by solid corporate earnings growth as companies rode on rapid economic expansion driven by both external demand for exports, as well as domestic demand from consumers and corporate investments.

Although the strength in emerging equities in recent years has narrowed the valuation gap substantially when compared to their developed market peers, overall, the structural case for the asset class remains strong.

This is evident in the improving debt ratings of emerging economies, with many of these countries now net creditors instead of debtors while holding more than two-thirds of global foreign exchange reserves.

Emerging economies have also become a force to be reckoned with, as gross domestic product (GDP) growth in each of the three zones consistently outpaces that of developed countries.

In addition, there is a tremendous potential for further expansion given the gap in personal wealth between first world and emerging markets, as well as favourable demographics that include a younger working population with rising disposable incomes and falling unemployment rates.

In Asia, prospects look generally bright in 2007. Already, Asia’s powerhouses China and India are flexing their financial might, as domestic companies make forays abroad, beating their better-known first world rivals and, in cases such as India’s Mittal Steel, even acquiring them.

Abundant liquidity should continue to support Chinese equities in 2007, alongside the renewed interest in initial public offers.

However, China-related shares have rallied in 2006 and valuations are no longer cheap. In addition, we remain cautious as investors’ reception to recent initial public offers point to a frothy market.

Although, from a top-down perspective, China remains one of the most exciting growth stories in Asia, we have found that the positives at the macro level have not been replicated at the corporate level, with many sectors suffering from overcapacity and operating in extremely competitive environments at the expense of profitability.

In India, the stock market is no longer cheap after scaling record highs in 2006, although corporate earnings growth remains strong.

Economic growth is also expected to stay healthy in 2007, backed by domestic spending, while demand for houses and government spending on roads, ports and other infrastructure projects is expected to give industrial production a boost.

Aberdeen retains an underweight to EMEA (Europe, Middle East and Africa), largely due to the region’s significant exposure to the highly cyclical commodity sector, particularly within countries such as Russia and South Africa.

Although the Russian economy has benefited significantly from the continued strength in crude oil prices, investors continue to grapple with issues such as poor corporate governance, unclear shareholding structures and opaque business practices, while having to contend with the poor regulatory framework and political interference in the private sector.

In particular, the Russian Government has tended to wield state-owned companies as a political tool, which makes us wary of investing in them.

While South Africa’s stock market is dominated by commodity companies, we remain upbeat about the prospects of the domestic economy.

Other markets in the region where we have identified well run consumer orientated businesses include Hungary, the Czech Republic and Turkey.

In Latin America, corporate governance is improving in Brazil, the region’s largest economy, particularly with the stricter listing requirements of the Novo Mercardo (New Market) trading segment.

Additionally, more companies are offering tag-along rights, ensuring minority investors and controlling shareholders are treated equally in the event of a bid.

Meanwhile, the central bank continues to lower interest rates, which have fallen by 3.75 per cent to 14.25 per cent over 2006 as inflation continues to ease. The reais has been volatile, especially during the mid-May sell-off, but has since appreciated. Politically, the close finish in the initial round of elections forced a second round of polls, which President Lula won with a comfortable landslide.

Elsewhere, Mexico’s economic fundamentals remain strong: the GDP growth rate for 2006 should approach 5 per cent while inflation is expected to continue easing.

On the political front, Felipe Calderon was finally confirmed as President despite accusations of vote rigging by populist rival Lopez Obrador. While the narrow victory margin casts a shadow over Calderon’s presidency, we remain upbeat about the long-term outlook for domestic companies.

Overall, the outlook for emerging markets remains sanguine in 2007. Market volatility is likely to rise as the prospect of slowing global growth persists, even though the magnitude of the deceleration in US GDP growth continues to be widely debated.

What appears more certain is the sound fundamentals that emerging economies continue to exhibit, with rising intra-regional trade, positive demographics and growing reserves — at both the state and corporate level — providing a buffer to cushion any potential decline in US growth.

There are, however, potential risks to the otherwise positive growth prognosis. Although emerging economies have increasingly de-linked from the US, a sharper-than-expected slowdown in the latter is expected to have an effect on the region, particularly for the more export-dependent countries such as Mexico and Taiwan.

Still-volatile oil prices and political uncertainty from presidential elections in Turkey and Korea, parliamentary elections in Russia, Turkey and Taiwan as well as leadership changes within South Africa’s ruling ANC party may have an impact on their respective markets. In any event, a pause at these levels would be healthy and even welcome, if only to allow earnings to catch up with share prices.

These concerns aside, the biggest worry for emerging markets could well be complacency towards reform and restructuring, which has, traditionally, taken a back seat when times are good.

Stuart James is associate director, business development at AberdeenAsset Management .