Prospects remain good despite dips

The MSCI Emerging Markets index halved in value since its peak a year ago with Russia suffering the biggest fall in the Bric region. But prospects for investors remain promising.

The three months to the end of September saw the worst quarterly performance on record for emerging markets. October proved even worse. The result: the MSCI Emerging Markets index has almost halved in value since its peak a year ago.

All the Bric countries (Brazil, Russia, India and China) have suffered, but Russian shares were among the biggest fallers (see graph). Scaremongering headlines announcing a new cold war, political tensions and the growing impact of the credit crunch have all contributed to heavy dips in recent share prices.

During August, Russia and Georgia, one of its most pro-Western neighbours, clashed over control of South Ossetia and nearby Abkhazia. The conflict saw Russia and the North Atlantic Treaty Organization (Nato) at loggerheads, which understandably sparked concerns about investment in Russia. However, problems relating to the global credit crisis had the most significant impact on shares, with authorities closing the stockmarket on two occasions while liquidity problems were resolved.

Measures were undertaken to help stabilise Russia’s economy, which is still one of the strongest in the world. Economic growth for the first half of this year was 7.9%. The country has more than $500 billion (£340 billion) in foreign exchange reserves, as well as strong fiscal and current account positions. The Russian government is the only world power that could replace all private sector deposits in its banking system with reserves.

Meanwhile, China has recognised the extent of the world’s financial problems with a marked reversal of monetary policy with authorities cutting interest rates three times. Its key one-year lending rate has fallen to 6.66%, following six years of rate rises. Recent data showed that China’s economic growth slipped into single digits for the first time in more than four years. This was because of the global slowdown, which is hitting exports – and weakness in the domestic property sector.

However, alongside these interest rate cuts, the Chinese government has announced the first steps in a big economic stimulus package, including low-cost housing and infrastructure spending, which clearly emphasises the shift from concerns about inflation to recognition of threats to economic growth.

In Latin America, the sharp fall in commodity prices has been responsible for the market’s decline. Resource-rich countries, like Brazil, suffered some of the biggest losses. The S&P GSCI Commodities index was down 28% over the third quarter, with nickel, for example, down 46% since the start of the year – making this the worst quarter for commodity prices since 1958.

In addition, currencies in the region faced a heavy sell-off, with the Brazilian real suffering especially big losses against most major currencies – exacerbating negative returns to foreign investors.

With many commentators proclaiming the death of the decoupling theory – what are the prospects for the emerging markets? In the short term, volatility is likely to persist. Investors are still risk-averse, and there have been substantial outflows from the asset class.

However, in the medium to long term, emerging markets equities are well placed. Compared with earlier financial crises, developing countries are in a much stronger position. This time around, the world is relying on the likes of China and India for growth, which is an excellent opportunity for longer-term investors.

Success will vary from country to country, as some nations are more reliant on the West than others. Mexico, for example, sends 85% of its exports to America. But even within Latin America, domestic growth and trade has picked up strongly, helping offset the effects of declining exports.

Throughout the developing world, domestic growth is being sustained by spending on infrastructure. People are flocking to cities to chase employment opportunities and to take part in their country’s economic boom, which in turn is putting added pressure on housing, roads, public transport, water and sanitation. This strain on infrastructure will get worse without increased spending.

Fortunately, the governments of many developing countries are in a good position to engage in big infrastructure spending projects, as they hold substantial reserves – a result of strong exports, or high commodity prices.

This comparative lack of debt is mirrored in the financial positions of companies and consumers. With less debt around with the potential to go bad, we are not seeing the type of blow-ups – Lehman Brothers, Bear Stearns, Northern Rock, AIG – that have plagued American and European markets.

The financial credibility of the whole region has improved in recent years. Brazil had its sovereign debt upgraded to investment grade earlier this year – testament to its progress in controlling inflation and maintaining a budget.

From a valuation perspective, the prospect for emerging markets investing has become more attractive. Traditionally, emerging markets equities have traded at a discount to their developed counterparts. However, towards the end of last year, this discount had all but disappeared, and some of the more highly-valued markets, such as China, were trading at a premium to developed markets.

So, despite the market sell-off, emerging markets are still in a relatively good position to be able to withstand the credit crunch and global economic slowdown.

In general, the asset class is characterised by countries with strong foreign exchange reserves, low corporate debt and high household savings. As a result, many of the countries in the developing world are benefiting from their comparatively strong financial positions, and represent excellent long-term investment opportunities