Emerging markets - the good, the bad and the risky

It can seem that deficits outweigh the benefits when it comes to investing in emerging markets at present but, as Milana Pokrajac reports, while some of the emerging market economies currently lack in appeal, there are still opportunities for investors to seize.

Improving investor confidence over the past 12 months may have given fund managers reason to be hopeful as they assessed the resurgence in appetite for domestic and international equities, but recent Investment Trends research has confirmed that most of the money was directed to the developed world with emerging market economies missing out. 

And this is something that is being reflected in financial planner recommendations, with the Investment Trends research suggesting the proportion of planners intending to recommend exposure to emerging markets fell from 53 per cent in 2010 to only about 35 per cent in August last year. 

Interest in single-region emerging economies, such as India and China, seems to have taken greater hits over this period, with the United States commanding the most attention. 

Weak sentiment in this particular area is understandable, according to van Eyk Research consultant economist and managing director of Heuristic Investment Systems, Damien Hennessy. 

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Hennessy said van Eyk had an underweight position in emerging markets, with three major factors impacting this decision. 

The most prevalent one is that the growth/inflation trade-off in most emerging economies had deteriorated and is continuing to do so. 

“That means that they’re having higher rates of inflation at lower levels of economic growth and I suppose that, in some respects, might reflect some maturing in the economy,” Hennessy said. 

“By and large I think the problem is that they’ve got some inflation issues and/or some current account issues.” 

This is creating what he called a “nasty dynamic” for capital inflow, currencies and asset prices. 

The other reason for bearish outlook is the deterioration of the so-called ‘growth premium’, ie, the difference between emerging markets’ GDP growth versus developed world growth. 

In 2005 through to 2009, emerging economies were growing by 4-6 per cent above the developed world. 

However, that growth differential has now slipped back to about 3 per cent - the lowest since the 1990s, said Hennessy. 

“I guess partly associated with that is the fact that return on equity now in emerging markets has also slipped below that of the developed world; typically it has been probably up to 2 per cent above developed world equities,” he said. 

“So there’s a bit of a problem there,” Hennessy said.  

Thirdly, a problem exists regarding their exposure to commodities and commodity-related sectors. Emerging economies attribute about 30 per cent of their revenues to commodities, which resembles the Australian market. 

But with commodity markets struggling to gain any traction, it is no wonder that at least some of those emerging markets are struggling to outperform, Hennessy said. 

It's not all bad

While emerging market economies lack in appeal at the moment, this is not to say there are no opportunities for investors to seize. The valuation aspect, for example, is nothing to sneeze at. 

Emerging markets are currently at a 30 per cent discount, Hennessy added. 

“The longer-term average is 15 per cent discount, so that’s a fairly significant discount compared to global developed markets,” he said, albeit adding the catalyst is not quite there yet for emerging markets to turn around. 

Cons still outweigh the pros, what with exposure to commodities, inflation and local political issues. 

Looking beyond equities 

It’s not all about equities, according to the Morningstar Emerging Markets and Asian Equities Sector Wrap-Up published last year. 

There are other ways to invest in emerging markets, and investors have the option of looking beyond the conventional method, the report stated. 

For example, debt - or fixed income - markets could provide a viable investment option, with the Emerging Market Debt (EMD) sector seeing its popularity rise in the last few years, receiving record flows from around the world. 

Investors can choose from sovereign, corporate and quasi-sovereign debt, and have the option of which currency to invest in. 

“From an investor’s perspective, EMD offers diversification due to the low correlation it enjoys with other asset classes,” the Morningstar Sector Wrap-Up stated. 

“Over the longer-term the sector has attained returns similar to emerging market equities but with a lower level of volatility.” 

However, it does not come without risk. At times of market turbulence, spreads can blow out compared to typical safe haven assets (such as US Treasuries), according to Morningstar. 

“This was certainly the case in 2008 during the global financial crisis. In recent years, the overall trend has been as one where spreads have narrowed, an indication of the relative economic health of the developed/emerging world.” 

Looking ahead 

Despite a huge drop-off in the number of planners intending to recommend client exposure to emerging markets, there are encouraging signs. 

One is the increase in appetite for global equities. The other is that the deterioration in growth pick-up that developing economies experienced over the last few years is not going to last forever. 

“They will still offer a pick-up in growth over and above the developed markets - it’s just getting through this tough phase,” Hennessy said. 

“I guess it’s a bit of a hangover from the very strong or excessive liquidity days that have helped propel a lot of markets, not just emerging markets,” he added. 

“Some withdrawal of liquidity in combination with high and rising inflation has created a very bad dynamic for emerging markets right now, but that’s not to say that medium- to longer-term they can’t outperform. It’s just that I don’t think we’re at that point just yet.”