A whole new world

In the eye of the savvy investor, emerging markets can do no wrong.

While many within the international emerging markets have posted extraordinary growth results in the past 12 months, buzz surrounding the future of the sector continues to deafen.

According to MSCI Emerging Markets data for year to date December 29, 2006, regions that fall within the sector, such as Eastern Europe, Asia, Latin America, and the BRIC economies (Brazil, Russia, India and China) are returning figures the developed world markets are forced to merely stare at mouth agape.

The data found Eastern Europe delivered a 40 per cent return, with Latin America returning 38 per cent and BRICs with 51 per cent.

In a further breakdown of the regions, China returned 83 per cent, Russia returned 54 per cent, while Venezuela returned a staggering 132 per cent.

Aberdeen Asset Management associate director Stuart James said investors are increasingly putting their money in emerging markets, with the International Monetary Fund (IMF) estimating the sector swelled with $418 billion of US private capital last year — a figure slightly down on 2005, which took a record $480 billion.

According to James, the emerging markets sector is split into three regions: Asia, Latin America, and Europe, Middle East and Africa (EMEA). Then there are the countries within these regions that also constitute entry into emerging markets. These include the Middle East and Africa, primarily South Africa. Other European countries included are Poland, Hungary and Russia.

“Emerging markets have a large exposure to commodities. In the case of India, it has a large population, 80 per cent live in emerging markets, with a population who are increasingly well educated. While it has a young population — 55 per cent of the population is under the age of 24 — they are going to be the workers and consumers of tomorrow,” James said.

“The IMF predicts that over five years emerging markets will grow 6.8 per cent, with developed markets growing 2.7 per cent. Predictions going forward: by 2050 China will be the world’s largest economy, with India number three, Brazil will be fifth and Russia sixth.”

AMP chief economist Shane Oliver said the bulk of local investors are putting their money in Asia, largely in part because they are more familiar with the region.

“I guess they feel more comfortable allocating towards Asia. Also, most emerging markets are getting their act together after 10 years. Because of the Asian crisis, investors are more familiar with Asia and there is a longer history specialising in Asia,” Oliver said.

OptiMix chief investment officer Emmanuel Calligeris said it is apparent investors are now choosing to place their money in emerging markets, preferring to invest in emerging markets within international shares.

“In general, we prefer growth assets over defensive assets; shares and property over bonds and cash,” Calligeris said.

“When economies grow quickly, companies have the potential to also grow quickly. So the benefits are that they’ve got growth rates which usually are higher than developed markets.”

IXIS Asset Management Advisors Group affiliate Loomis Sayles & Company emerging market debt strategist David Rolley said the benefit of investing in the sector is its diversification and returns.

“Many of these markets have higher inflation-adjusted real yields than the dollar, Euro or Yen markets. Investors may also be paid for successful dis-inflation, as in Brazil. Investors can also access higher growth stories, as in non-Japan Asia,” Rolley said.

According to Oliver, another key benefit for investors investing in emerging markets is the sector’s ability to deliver a high rate of return.

“Because the countries are growing strongly it tends to give greater rate of return. So you end up with higher returns. Some of them also come with more attractive evaluation, they tend to trade on lower PE [price per earning] — lower than the US or Australia,” he said.

“The forward PE tends to be a bit lower, which means the market tends to be a bit cheaper. Not so much relative to Australia, it’s high in Australia. If you buy into an exposure in Japan, in Asia it’s about 3 PE. That’s in contrast to the mid 90s … when Asian shares peaked, the forward PE were pushing 20 times, whereas these days they’re 13 or 14 times. The valuation today is attractive to other countries and still 10 years ago because of the Asian crisis,” Oliver said.

James agreed, offering further comment based on the emerging markets’ population, rather than market growth.

“They tend to have saving rates by saving a high portion of their income. They are also very underleveraged, with no credit borrowing. Mortgages — as a percentage of gross domestic product — are 65 per cent in the US, [as opposed to] 5 per cent in Poland, 1 per cent in Saudi Arabia, 2 per cent in Brazil, and 5 per cent in India and Asia.

“[With] high savings not greatly in debt, there is good potential for consumer consumption and building domestic demand. From a macroeconomic view, economies are stronger than they were. Many of them have current account surpluses, and have large foreign exchange reserves,” James said.

While many investors happily rub their hands together at the thought of continued strong performance and tales of high rate returns, there is indeed a downside to emerging markets.

Just as China and Venezuela have dominated the high performance, there are also the abysmal performers. The MSCI Emerging Markets data found Israel returned negative 14.3 per cent, with Jordan returning negative 31 per cent.

“I wouldn’t be putting all the money in the sector,” Calligeries said.

“I think the emerging markets are more stable than they were in the past. We are unlikely to experience another Asian property crisis. On the flipside, they’ve become slightly more stable. How stable? [There is still] political risk with a lot of these countries.

“One thing is for sure, they seem to be more stable than they were before once governments have made the positive movements and noises to start putting their country on a growth path, an industrialising growth path where you get the type of India and China trends that have been happening,” he said.

James put it simply: “Emerging markets are less stable.”

He said while the market has improved since the Asian crisis a decade ago, political interference has emerged as the sector’s new distracter.

“Investors do need to be careful about the quality of the companies. A lot of companies do lack transparency,” James said.

“You find companies in Malaysia have a lot of government contrasts, which need to be taken into account.

“The main threat to emerging markets is a slowdown in US growth. The big fear [is this] could cause international liquidity to dry up and, therefore, investments into emerging markets could increase. Generally, emerging markets are more self-sufficient, with inter-regional trade meaning trade has fallen from the US. Say growth was to fall 0 per cent next year, China would still grow by 8 per cent. Therefore, emerging markets are more robust. The problem is, if the US was to slow down, that would spook investors. When investors are nervous they sell their riskiest assets first, meaning emerging markets,” James added.

Rolley said the downside to emerging markets is the sector’s risks, including global liquidity risks.

“Risk aversion can lead to foreign investor exit, producing sharp price declines, as we saw last year in, say, the Indian stock market. Investors also face policy risks that are greater than in the developed countries. The threat of default by Ecuador is an extreme example of this,” he said.

Oliver said because of the sector’s volatility, the growth of emerging markets tends to run off the rails.

“All the emerging markets come with political risk. Asia seems to be safer, and while Thailand had a coup, [Asia] tends not to be a political [risk],” he said.

“The good thing is it’s not a generalised trend. I think Asian economic policies are sensible, there’s always conflicts between political parties, which tend to be minor. The policies are generally better; you don’t have as much exposure to commodities, so it’s a complementary fit to a degree.

“Ten years ago you had Asian countries which were low on capital inflows and high on debit level and corporate and foreign debt, whereas today it’s the other way round. The US is now running a high trade deficit. The actual fundamental risk is greater for the US than emerging markets,” Oliver said.

So would it be fair to say the sector is bordering on being over-hyped?

“I don’t think it has. It’s in danger to become so,” Oliver said. “Emerging markets have had pretty spectacular returns over the last four years. As investors become more comfortable in investing and more comfortable with their own markets they tend to look abroad. Normally, there’s a bubble when the PE is trading much higher. In the case with Australia or the US, then you’d start to wonder if there’s a bubble. You could say there’s hype about India and China. China has really only gotten back to where it was five years ago,” he said.

“So it’s too early to say it’s in a bubble. The Indian share market is a little over-hyped — the share market is the most expensive, trading on the highest PE. It’s probably the riskiest; it’s had a huge run over recent years. If PE pushes, 20 emerging markets might get over the top. The risk of getting a major fall is steadily rising. We’re going to have corrections like we did last year, but as long as it remains favourable the market will rebound,” Oliver added.

In contrast, James believes hype is a factor in the emerging markets story.

“Yes I do. I think because investors get caught up in the macro story; they read about growth and they tend to get bullish about the macro story in emerging markets.

“You make money in investing in good companies not good countries. Money going into BRIC economies found its way to China, listing Chinese banks. From an investment point of view, China isn’t that strong. There’s a lack of transparency. Long-term — not hyped; short-term, yes, hyped,” he said.

Rolley also believes there is a chance the sector has fallen victim to hype.

“Probably — the opportunities are real, but 15 years of outperformance has probably produced excess enthusiasm and a disregard of the genuine risks. The doubling of the Chinese equity market in 2006 was probably an example of excess liquidity chasing too few good investable ideas.”

Calligeris takes a broader approach to questions of sector hype.

“At the moment, it seems like the whole world is suffering a bit of hype. It’s being driven by buoyant liquidity conditions. Is it more so in Asia? It doesn’t seem to be. But I think you have to be selective in the way you invest in emerging markets, because there is an opportunity to make returns,” he said.