Weighing up investment in emerging markets

As emerging markets continue to be hailed as the way forward for investors, Nick Price considers the pros and cons of the sector.

Almost two-thirds (65 per cent) of the world’s population are in emerging markets and contribute almost three-quarters of global gross domestic product (GDP) growth.

Yet these countries still account for just 13 per cent of the global stock market. Likewise, many still think of global emerging markets (GEMs) as risky investments, even though 57 per cent are considered to be investment grade.

As debt-ridden developed markets struggle to make economic headway, it is time for investors to turn their attention towards the emerging powerhouses. The dramatic differential between the market role and economic influence of emerging markets will not continue indefinitely.

Indeed, progress to close the gap is already being made.

Developed market investors are being attracted by businesses that are well managed, transparent and focused on shareholder value.

They are also attracted by a growth premium fuelled by long-term structural drivers that have helped the region quickly overcome the recent global economic slowdown.

Favourable demographics

A large majority of emerging markets have ‘bottom heavy’ demographic profiles, where a large proportion of the population falls into the most productive age bands between 25 and 59. This creates an abundance of low-cost labour to boost economic development.

Cost-conscious consumers in the developed world favour cheaper goods and services, playing to Asia’s competitive manufacturing strengths.

Some markets have invested in education to build cheap but also highly-skilled workforces in sectors such as technology. India has carved out a sizeable niche in this market, as has South Korea and Taiwan.

However, the country most likely to make a global impact through labour force up-skilling is only just beginning to start down that path — China.

Natural resource advantages

Some 90 per cent of the world’s proven oil reserves are to be found in emerging markets. Likewise, commodities such as copper, gold and platinum are abundant in Latin America.

These riches have been successfully harnessed through the development of world-leading producers such as Chile’s Codelco and Brazil’s Vale.

Looking ahead, demand for raw materials is increasing in emerging markets, as their population moves from rural areas into the city and necessitates the building of new infrastructure, and also in the developed world, as inventories are rebuilt and ageing infrastructure is replaced as part of the various stimulus programs enacted in response to the economic slowdown.

Rise of the consumer society

Whether it is from manufacturing or commodities, there is no escaping the fact that wealth in the emerging markets is on the increase.

The expanding middle classes of the developing world are eager consumers keen to emulate western lifestyle, so western companies are rapidly rolling out their brands to take advantage of this trend.

However, local competitors are also expanding to cater exclusively to the tastes of the emerging market consumer.

As consumption increases and local wealth is invested in infrastructure, domestic demand is replacing the traditional reliance on international trade.

Emerging markets are no longer just another link in the global supply chain — they are becoming end markets in their own right. As this happens, it makes the arguments for economic decoupling from the West all the more resilient.

Risks

However, while such wide-reaching transformation leads to many of the traditionally perceived risks of investing in emerging markets being reduced, one should not assume that all risks have been eliminated.

Political instability continues to affect some countries, other regimes may nationalise institutions without warning and a few could impose controls on capital flows that impede overseas investment.

Furthermore, there are new risks to consider.

For example, another round of US quantitative easing and a weaker dollar is likely to encourage more investment flows into emerging markets, fuelling worries that market bubbles may emerge.

Indeed, China’s stock market performance has drawn comparison to the technology bubble of the late 1990s.

However, it can be argued that the Chinese story has more sustainable foundations and the Chinese government has also shown itself to be effective in managing economic growth in the past.

With these and other risks in mind, emerging markets have traditionally traded at a discount to their developed neighbours.

However, this thesis may be due for a revisit. The superior economic position of the developing world is now being reflected in more attractive company earnings projections and it can only be a matter of time before equity markets more fully reflect these fundamental advantages.

Regardless of any short-term volatility in equity markets, the transformation of emerging markets will continue. As such, they are still a gem of an idea for long-term investors.

Nick Price is emerging markets portfolio manager at Fidelity Investment Managers.