Have emerging markets peaked?

Riding in the slipstream of the year-long rebound of developed equity markets, emerging markets have collectively delivered stellar returns for investors over the past 12 months.

But while investors are unlikely to suffer at the hands of a new Asian crisis or economic meltdown in places like Argentina, it appears last year’s performance will be “as good as it gets”.

According to Merrill Lynch Investment Managers head of asset allocation David Hudson, the market can expect an element of US Federal Reserve monetary policy tightening this year — an environment in which emerging markets tend not to fare well — and the movement of the economic fundamentals away from their present investment-favouring peak.

“The case for emerging markets is still strong in terms of valuations and the economic cycle being in favour.

“However, we appear to be close to the peak global economic growth cycle and as a consequence, the case for being overweight in emerging markets is running out of steam,” Hudson says.

Another reason for caution, Hudson says, is the US cash rate is down at 1 per cent — a figure that cannot be sustained, therefore rates are likely to rise in the next 12 months.

Platinum Asset Management portfolio manager Andrew Clifford agrees with Hudson’s assessment of the market.

“Emerging markets have had a very good run over the past 12 months, but what we’re now seeing is a lot of new IPOs (initial public offerings), and secondary raisings by companies that are weighing heavy on the markets,” Clifford says.

The MSCI Emerging Markets Free Index was up 16.8 per cent for the 2003 calendar year, but over a three-year period, was only up 1.9 per cent.

According to Hudson, and despite solid 2003 performance and valuations remaining reasonable for the early part of this year and perhaps into the second half, investors are unlikely to reap significant returns from emerging markets.

“In a strategic sense, valuations are quite attractive and much more attractive than developed markets, so investors would want some exposure to emerging markets, but in a tactical sense they wouldn’t want to be overweight,” Hudson says.

Conversely, Deutsche Asset Management international equities investment specialist Bill Barbour remains bullish on the sector, saying valuations remain cheaper than they are in developed markets, despite the recent surge in many emerging market stocks.

“We invest in companies and not countries or regions and we believe there are opportunities at the individual stock level to enable emerging markets to continue to offer good returns.

“Valuations remain attractive, profitability is still on the rise and I think the major macroeconomic factors out there are manageable,” Barbour says.

Meanwhile, Clifford argues that while market movements continue to demonstrate a high correlation with developed markets, this has more to do with the long held sentiment of the investment community, as many emerging markets are in fact domestically driven as opposed to being reliant on exporting to more economically mature countries.

“These markets are still closely correlated with developed markets [in the eyes of those who have influence over market movement], however, we think as time goes by, emerging markets will become less impacted volatility-wise by the movement of developed markets,” he says.

However, US-based fund manager Nicholas Applegate portfolio manager Michael Fredericks believes while many emerging market companies are globally competitive, exports to developed markets account for a large portion of their generated revenue.

“Samsung Electronics constitutes more than 7 per cent of the MSCI Emerging Markets Free Index — the most commonly used benchmark for emerging markets equity. More than 55 per cent of sales are generated outside of Korea, with 45 per cent of goods sold to Korean companies largely for inputs that are, in turn, exported,” Fredericks says.

According to California-based Fredericks, other companies highly reliant on export and international economic growth include firms such as Russia-based Yukos oil (75 per cent of revenue is from exports), Israel drug-group Teva Pharmaceuticals (90 per cent), and any of South Africa or Brazil’s mining companies, which he says are entirely dependent on exports.

Fredericks is also of the belief that emerging markets are comprised of thousands of companies that fall into two distinct camps — a handful of large cap globally competitive firms and a second group of firms yet to debut on the global stage.

He adds companies in this latter group have a high growth potential but are much more dependent on country or regional growth prospects for share price appreciation.

“The global drivers in large-cap are best exploited by an international or global equity manager given discretion to invest in emerging markets opportunistically.

“Whereas investment in small to mid-cap stocks is best exploited by a manager with an acute understanding of the country-specific factors that drive performance,” Fredericks says.