Investor sentiment towards emerging nations has changed dramatically as their economies benefit from better management and banks become increasingly willing to lend to consumers.
In a year dominated by uncertainty, rising risk premiums and concerns about the health of the financial sector, many investors may not be aware of just how well emerging markets are performing as an asset class. In the year to October 31 the MSCI Emerging Markets index had risen just under 20%, with markets such as America, Britain, Europe and Japan all struggling to beat 7% (figures in sterling terms).
However, it is not just the headline market figures that have impressed. Traditionally, a rise in risk premiums has been seriously bad news for emerging markets, but most emerging countries have appeared oblivious to the problems spreading from America. Volatility has increased: the index fell 20% from peak to trough in August, but recovered nearly all lost ground by the end of the month and continued to make strong gains in September and October.
Something has changed in investor sentiment towards emerging markets. I think that there are two aspects to this change. The past 20 years have seen numerous crises in emerging markets. These have inevitably been caused by internal financial problems – high and unsustainable current account deficits, excessive foreign-denominated debt and runaway inflation being the chief culprits.
Such economies are generally being managed more sensibly. Indeed, tighter fiscal policy means many emerging markets are now net creditors. Currency regimes have been liberalised, debt to GDP levels have fallen and there has been a rebalancing of debt from foreign to domestic denomination. Inflation has been brought under control, and interest rates have therefore come down. The combination of prudent economic policies and strong growth have brought emerging market debt spreads down from about 900 basis points at the start of the decade, to about 200 today.
Underpinning many investors’ thinking about emerging markets is that they are a simple commodity play, or that the only markets that count are China, India and the other Bric countries, Brazil and Russia. At an index level, these are fair assumptions – materials and energy account for about one third of the index, while the Bric countries account for about 60% of the MSCI. However, looking at the index misses the point. In my view, emerging markets is about growth and development, and in particular the way in which releveraging and latent demand will boost these trends.
Governments across this asset class have realised that if they want to continue to see strong economic growth of the type they have enjoyed in the past 10 years, they need to invest. Many cut infrastructure spending in the late 1990s to try to balance the books, but are increasing investment budgets. Transport links (ports, rail, road and air), energy generation and housing are all priorities. GE estimates about $3 trillion (£1.5 trillion) will be invested in emerging market infrastructure over the 10 years from 2005 – a more than threefold increase on the previous decade.
Another theme affecting emerging markets is changing consumer behaviour. As inflation has decreased and interest rates come down, banks have become increasingly willing to lend, as seen by the growth in mortgages. Previously, these had not been an option for most people, either because the cost was too high or because earlier lending sprees meant that balance sheets were saddled with non-performing loans and hence new lending was severely curtailed. Alongside the wider availability of credit and lending, the new middle classes are spending an increasing proportion of their rising income on consumer goods and services, rather than maintaining the traditionally high savings ratios of the past.
Investing in emerging markets always adds risk to a portfolio. Investors need to be aware of the top-down factors that can hurt performance, reducing exposure where there is political risk (for example, Venezuela), or where valuations are getting significantly out of line (China). The solution remains relatively simple: buy stocks that have strong fundamentals and are attractively priced, and pay attention to top-down factors that could blindside a portfolio.
Fund flows will continue to play a part in emerging market moves. The strength in Chinese equities recently has partly been because of the huge volume of money looking for a home. While short-term factors will affect flows, this is underpinned by a strong long-term positive – pension funds. Chile’s successful pension experiment has been exported widely, with many emerging markets building large pools of domestic assets; many have low equity weightings (less than 50%) with countries such as Indonesia, Korea and Mexico allocating less than 10% to equities.
From a market perspective, several factors may cause some short-term wobbles for emerging market equities. We could be due a pull-back following strong gains since August, and supportive fund flows may recede if further credit problems emerge, or if growth in developed markets slows more than expected. However, the mediumto long-term picture remains positive. While economists have been downgrading American and European growth estimates, emerging market GDP growth estimates have risen to 8.2% for 2007, and 7.7% for 2008. Valuations are now at a slight premium to developed markets, but this seems justified given that economic growth rates, corporate earnings and return on capital comparisons all favour emerging markets. Market performance over the past five years has generally been driven by earnings growth rather than multiple expansion, meaning the scope for a de-rating of the market is limited.
However, much more important are the huge secular trends highlighted above. The growth potential over the next 20 years within this asset class will not be affected by relatively short-term issues such as the American subprime crisis. Emerging markets account for 80% of the world’s population but only 32% of its GDP and 7% of its market capitalisation. Expect these last two numbers to keep rising.