Region offers rewards despite risks

The MSCI Emerging Markets index outperformed the World index by a fifth during 2007 – and emerging stocks still offer value for the shrewd investor despite a smattering of risky factors.

Have emerging markets finally decoupled from those of the developed world? Investors have been embracing them with an enthusiasm that appears at odds with the additional risks that are associated with them. After all, that is why they are termed “emerging”. If the risks inherent in investing in them, which might be political, social, economic or climatic – or even a combination of them all – were not present, then arguably these markets would have “emerged” already.

But the performance emerging markets have collectively delivered is impressive to say the least. During the first 11 months of 2007 the MSCI Emerging Markets index has outperformed the World index by a fifth. Indeed, earlier this year the price/earnings multiple on the Emerging Markets index rose above that of world equities. So much for pricing in additional risk.

But there do appear to be good reasons for backing these markets against those of the developed world. So far they have been relatively unaffected by the turmoil that has been engendered by the credit crunch. Moreover, in much of the developing world a savings culture has taken hold, suggesting these countries are less vulnerable to any downturn in economic activity that might result from the twin problems of tighter credit conditions and a decline in property values that are assailing America and Europe at present.

This is not to say, though, that emerging countries will be able to shrug aside a fullblown recession emanating from America. All the indications are that consumer spending will turn down in the New Year as the American public retrenches in the face of rising inflation and falling house prices. Similar pressures exist in Britain too. With much of the emerging world’s wealth predicated on selling manufactured goods and other services more cheaply to willing Western markets, there will be some pain as demand retreats.

Even so, the financial strength of some of these countries is impressive to behold. The foreign exchange reserves of the Bric (Brazil, Russia, India and China) nations far exceed those of America and Britain. In America’s case, reserves have been ravaged by the large, damaging deficits they have accumulated. And the economic and corporate power that is building in the emerging world is beginning to create a momentum all of its own. It is not fanciful to suggest that the woes present in the developed world’s financial system could accelerate the transfer of wealth ownership to emerging nations.

It would be foolish, though, to deny that risks are not present in these markets or to treat the emerging world as a homogenous entity. The dynamics and characteristics of those countries that are termed emerging are as diverse as you can imagine. China has the population, the manufacturing capacity and the determination, both at a governmental and an individual level, to become a world leader, if that accolade has not been won already. Yet it suffers potentially disastrous environmental and social problems that may yet upset its hitherto impressive growth record.

Similarly, any observer of the Russian political and business scene will be only too aware that democracy, transparency and fairness are qualities yet to be embraced by this former superpower. However, underestimating the ambition of Russia and its leaders would be unwise, to say the least. The wealth enjoyed by this nation through its ownership of natural resources will be directed forcefully in the future, although whether this will be to the benefit of the rest of the world is hard to predict.

As for the private investor seeking to gain advantage from the enfranchisement of most of the world’s population – a majority that has lacked economic clout until recently – it has to be admitted that the easy money has been made. All five of the best-performing funds over the past five years would have pretty much quadrupled an investor’s money. The best-performing fund, Jupiter Emerging European Opportunities, has multiplied in value five-fold.

Even the worst performer over the five-year timeframe – Credit Suisse Multi Manager Emerging Markets – has delivered a gain of more than 183% to the end of November. Despite the difficult conditions that exist in many of these markets, with corporate governance, accounting standards and transparency far lagging the developed world, fund managers have found conditions favourable for some time now.

There is some impressive consistency among the leaders, too. F&C and JP Morgan both have funds that feature in all of the six months and one, three and five-year tables. Sadly, the only Templeton fund to feature in the IMA list, Global Emerging Markets, languishes in third and fourth quartile ranking, but has still delivered gains that would have been perfectly acceptable in other sectors. With Templeton’s Dr Mark Mobius still regarded as the doyen of emerging markets investors, it demonstrates how much resource has flowed into this sector in recent years.

For the future, this remains a part of the global investment map that will surely continue to feature strongly in growth investors’ portfolios. In the near term, though, the winds that are blowing through financial markets may yet create conditions for a retrenchment that will bring valuation levels back to more acceptable levels. Remain committed to this sector by all means, but do be prepared for some bumpy conditions ahead.