Emerging markets outshine the rest

Optimism that emerging markets can weather a downturn in America had them outperforming their peers in October. But a correction last month left China and Hong Kong the main losers.

Most global equity markets reported gains in October, but outperforming their peers in the developed countries were those of the emerging markets, which rose on optimism that their economies will be able to weather a downturn in America.

In Asia, the Hang Seng, Bombay Sensex and Jakarta Composite Indices all chalked up strong double-digit gains, while in Latin America, Brazil’s Bovespa index continued to power ahead on the back of a favourable political and economic outlook. In Russia the RTS index also delivered a good return.

Indonesian stocks were bolstered after the country’s central bank left the interest rate unchanged and hinted in early October that an interest rate cut might be possible by the end of 2007. Mining and energy stocks led the stockmarket on speculation of rising demand from China for natural resources products. Telecom stocks also contributed to the rally in the equity market after reporting satisfactory operating figures.

In India, panic selling broke out on October 17 after the Securities and Exchange Board of India, the country’s stockmarket regulator, proposed new regulations that might deter foreign institutions from investing in Indian stocks.

The Sensex 30 index plunged by almost 10% during the day. However, the equity market staged a robust recovery towards the end of the month as the regulator scaled back the restrictions.

In Hong Kong, equities continued to be driven by abundant market liquidity. The increase of banks’ reserve requirement ratio in China and speculation that the Chinese government would introduce more measures to cool its economy failed to hinder the rally in the stockmarket.

Also, market beating third quarter 2007 corporate earnings of China-related stocks, initial public offerings of more H-Share stocks’ A Class shares in the Shanghai Stock Exchange, and a better-than-expected public land auction in Hong Kong provided the catalysts to boost equities higher.

The Investment Management Association’s (IMA) Global Emerging Markets sector returned an average of 7.45% in October, making it the top performing sector overall for the month. The Lipper Global Classification Indices, which track fund investment in different geographies and sectors, list the top performing equity regions for the month as India, Indonesia, Hong Kong and China.

If we look at the leading global emerging market funds that contribute to Lipper’s Asset Allocation Analysis, we can see that the key to providing the edge in performance terms this month is supplementary investment in Hong Kong, South Korea and/or Malaysia.

The Allianz RCM Bric Stars Fund returned 11.85% in October alone. In addition to the success of the Bric (Brazil, Russia, India and China) regions, it has significant holdings in Hong Kong, whose markets returned over 15% for the month. This relatively new fund, launched in February 2006, has returned over 80% for the year to October 31.

Another Bric-type fund, the F&C Emerging Markets fund, returned 9.84%, with the healthy returns provided by its 15% holding in Korea and smaller investments in Malaysia and Indonesia giving them the advantage.

Less concentrated than the funds above, but still returning 9.29%, the Axa Framlington Emerging Markets Fund also benefited from investments in the Bric regions, Korea, Malaysia and Indonesia.

But it is not just the short term that has seen compelling returns in this sector. Global Emerging Markets has been the best performing sector over both three and five years, and over 10 years it has proved to be the third-best performer.

However, after all the good news, a reminder that emerging market funds are not for the faint-hearted. The inherent risks associated with investing in global emerging market regions are reflected by the low Lipper Leader ratings these funds receive for capital preservation.

Compared with other equity sectors, there is greater potential for emerging market funds to suffer from capital loss, underlining the risk that these funds could fall in value.

As if to prove the point, global equity markets have undergone a sharp correction since the beginning of November, following continued reports of a series of American subprime loan-related problems, with China and Hong Kong being the main losers. Only the India S&P CNX 500 clings on to a positive return at the time of writing.

The impact on emerging markets of a possible American recession is a further point to consider. However, those who think its effect on emerging economies will be lessened owing to their diminishing reliance on America for imports/exports may be disappointed.

If a valuation is built on over-enthusiasm rather than fundamentals, fear can more easily take its toll. Emerging economies may be able to stand on their feet more than they have in the past, but any stockmarket that has the suspicion of over-valuation is always sensitive to bad news.

In the meantime, investors will closely monitor further developments in America, particularly for news of a renewed deterioration in the housing market and consumer activity.

With the perception of risk increasing, capital may continue to be parked with low-volatility investment products such as government bonds, and equities may continue to deliver a lacklustre performance.

An uptrend is unlikely to occur unless new catalysts emerge to convince the markets that all the American subprime loan-related problems are behind them.