Emerging markets that will lead us through the next 10 years

Australian Financial Review: Smart Money, October 2011

This won’t be the first time you’ve read that emerging markets are becoming the engines of global growth while North America, Europe and Japan decline. But beyond the broad statements, the evidence is really starting to pile up to prove it.

Consider this. There have been 34 global corporate defaults so far in 2011, according to Standard & Poor’s. 24 of them have been American, three in the European Union, and most of the rest in places like Canada and New Zealand; only one apiece in Israel and Russia could be considered emerging markets. In 2010 there were 49 from the US and 11 from other developed nations compared to seven from every emerging market in the world combined. Fund managers will still tell you that in volatile times, they reduce risk and flee emerging markets – but the truth is, with every passing year, emerging markets become less risky and more like safe havens.

For the moment, capital flows still flood out of places like Asia and Latin America every time there’s a global shock, no matter how illogical that might at first appear. “Asian markets are still peripheral markets for major global institutions,” says Kerry Series, chief investment officer of 8 Investment Partners, an Asia-focused fund manager in Sydney. In the MSCI Developed World Index, for example, Asia Pacific ex-Japan accounts for just 6%, including Australia and New Zealand; beyond Hong Kong and Singapore, every other Asian market is not part of the benchmark many global investors track, “and allocations are likely to be cut when short-term performance pressures occur.” The fact that Asian pension funds and other major institutions are still somewhat in their infancy in Asia and Latin America gives retail investors a bigger role, adding to volatility.

But the long-term story is widely embraced. “We believe emerging markets offer a far superior economic outlook,” says Garry Evans, strategist at HSBC in Hong Kong. HSBC is calling roughly 6% growth in emerging markets this year and next – a cooling, sure, but by comparison, Evans says the developed world is “trapped in a permafrost”. On top of that, while economists had become increasingly concerned by the prospect of inflation in Asia, that concerns has been wiped out for the moment by growth prospects; from Brazil to China, central banks have stopped tightening, with Brazil going so far as to start cutting rates (albeit to a hefty 12%).

Evans agrees that seeing emerging markets assets as risky, and therefore flighty, is wrong. “In many respects, EM assets could be viewed as offering defensive characteristics in the current risk-averse environment,” he says. “Let’s not forget that the current threat to global growth is coming from the sovereign debt crises in the developed world and the associated pressure on its banking system.” He continues to like emerging market equities “for a whole host of reasons such as better demographic trends, more sustainable government fiscal positions, healthier household sector balance-sheet and a likely shift in asset allocations towards the region.”HSBC’s valuation model, called trend-adjusted PE ratio, puts emerging markets at a 9% premium to the rest of the world, “but this is a price worth paying,” he says, noting that HSBC prefers Asia as a region, and in terms of individual markets, likes Taiwan, Russia and China.

Increasingly, emerging markets are not just about the future but the present. Last week [Oct 13] Cap Gemini, with Merrill Lynch Global Wealth Management, released its closely-watched Asia Pacific Wealth Report, which found that Asia had overtaken Europe as the world’s second biggest market of high net worth individuals, measured either by population or combined wealth; on either measure, it’s only a matter of time before it overtakes North America for the top spot.

“Emerging, including Asia, markets are likely to move to substantial valuation premiums to the major developed markets during the next 10 years,” says Series. While developed markets are weighed down by high household and government debt, meaning lower growth as that debt is deleveraged, “the emerging markets, especially Asia, will continue to generate high GDP growth. Investors will pay a premium for growth in a growth-starved world.”

ASIA

In Asia, the big question is just how closely tied the economies and markets will prove to be to global problems. Every time a new period of financial turmoil approaches, the same question arises: will Asia be insulated? Is it different this time? It never is.

But the picture varies from place to place. “Taiwan, Singapore, the Philippines and Malaysia are the economies most leveraged to global growth,” says Wai Ho Leong at Barclays Capital in Singapore. “Higher leverage implies a faster transmission of external growth shocks into domestic demand and employment conditions.” That then feeds through to exports.

On the other side of the coin, the best-positioned Asian economies should be those with strong domestic consumption and diversified exports: Indonesia, India and China. The latter two are covered separately but Indonesia has been the darling of emerging market investment in the last few years: a new but successful democracy, growing foreign exchange reserves, vastly improved fiscal position, a wealth of commodities, and huge domestic growth. The thorn in its side has been inflation – but the latest global shock has pretty much taken care of that. “Inflation appears to have peaked around the region and last week saw initial easing of policy in several countries,” says Series, referring to China, Indonesia and Singapore. “In 2012, it is likely that Asian economies will be in an easing phase as inflation falls and this will be very supportive for Asian equity markets.”

At the recent market low in October, Asian equities ex-Japan had moved to 1.5 times price/book, just 20% above the low of the GFC despite much better profitability now – 14% return on equity compared to 8% in 2009. “The recent sell-off has provided investors with another great opportunity to increase their exposure to Asian equities at low valuations,” Series says. He favours resource and domestic Asian consumption stocks.

CHINA

“If investors thought China could save the world back in 2008, they now think China just might sink with it.” So says Steven Sun, head of China equity strategy at HSBC.

This is a perennial question not just for investors with exposure in China, but anywhere in the world, so crucial is China’s strength to the world economy now. Hard landing or soft? Inflation problems or not? The markets certainly haven’t liked what they’ve been seeing, as Chinese equity markets lost 30% in the third quarter of the year.

Many people believe it is cheap. By early October China (through the MSCI index) was the cheapest stock market in Asia, trading at 1.4 times 2010 price to book ratios – almost 10% lower than the market bottom in 2008 – and seven times 12-month forward price-earnings ratios. “The sell-off is overdone, in our view,” says Sun. He also notes that financials, industrials and materials have sold off by about 60% versus their five-year averages, compared to just 20% for consumer and IT stocks. “This shows us what may be the real driver of future growth in China: consumption.”

A key question revolves around inflation, and last week [Oct 14] CPI eased to 6.1% year on year, with analysts expecting continued moderation. This has a big impact on monetary policy, and therefore conditions for growth. “As inflationary indicators continue to ease, the government will likely pause on its tightening campaign,” says Jing Ulrich, chairman of global markets for China at JP Morgan. “In the remainder of this year, policy focus will shift to maintaining steady GDP growth and employment,” among other things.

It’s important to note that most people with China exposure aren’t actually buying domestically-listed Chinese shares, or A-shares; instead the more common way is to buy those shares that are listed in Hong Kong, called H-shares (if the company is Chinese) or red chips (if it is legally a Hong Kong company but almost all of its money comes from China). Today, funds available in Australia – and there are several, from names as big as Fidelity and Aberdeen – usually invest in H-shares, while the ASX-listed investment company from AMP holds A-shares.

INDIA

Last month Russell Investment chief investment strategist for Asia Pacific, Andrew Pease, argued that India was the most compelling market for investors considering investing in Asia. “The relatively attractive valuation, combined with the easing of inflation pressures, peaking in the tightening cycle and India’s defensive characteristics heading into a global slowdown, put this market at the top of our list,” he said.

Well, if it was an attractive entry level then, it’s more so now; the BSE 30 index, which tracks the 30 biggest stocks listed in Mumbai, fell just over 8% in three weeks in September, and has not yet regained the lost ground.

India is partly a demographic story, like China: the two of them combined have three times the population of the entire developed world. It is, more than anywhere else, a story of potential, with per capita GDP of just $1,500 today despite unarguably becoming a world power.

Corruption and governance are big issues, as are slow progress in bringing about vital infrastructure development; additionally it has the highest percentage level of debt of the big emerging economies (though well short of debt-laden developed world nations like Japan) and has constant challenges with inflation. Short-term, some are bearish: Nomura expects real GDP growth to remain below potential [it was 7.7% year on year in the second quarter of 2010, which sounds pretty good anywhere else but represents a decline in India) and is calling 7.9% growth in 2012, though on the brighter side it expects headline inflation to drop from 9.8% (August) to below 7% by March.

But the sense of India finding its place in the modern world is exhilarating, and the long-term possibilities are enormous. “Economic indicators are not uniformly flashing red,” says Taimur Baig, economist at Deutsche Bank. “Tax collection and trade data suggest steady economic growth. The economy remains on a better footing than it was in 2008.”

Examples of India-specific funds sold in Australia are from Fidelity and Fiducian.

EEMEA

This clumsy abbreviation stands for Eastern Europe, Middle East and Africa – which basically means lumping together a load of places that don’t really fit anywhere else. South Africa has about as much in common with Poland or Qatar as Tony Abbott does with Mahatma Ghandi, but nevertheless these nations do tend to be treated as a group by global fund managers and by big multilateral institutions such as the World Bank.

Clearly each part of the group needs to be considered separately. Emerging market funds from Australia will only tend to have exposure to a few of these places; the Aberdeen Emerging Opportunities Fund, for example, has only one stock (the Turkish bank Akbank) from this region in its top 10, while Templeton’s Emerging Markets fund gets its exposure from Russian energy and commodity plays like Lukoil and Gazprom. Russia, as a BRIC member, attracts a lot of attention, while other countries in this region that attract funds include South Africa (which offers a combination of high rates, a relatively well developed local bond market, and good fundamentals), the Eastern European members of the EU (particularly the longest-standing ones: Poland, Czech Republic and Hungary), and – at least until recently – Egypt, one of the oldest and deepest stock markets in the region.

The Gulf is an odd part of the world in market terms. Economies like Saudi Arabia and Kuwait would normally be expected to be big parts of international capital markets, seeing as they are so rich and replete with hydrocarbon wealth. But their markets are not sufficiently open to be included in international indices like the MSCI Emerging Markets index, so index providers still class them as frontier, meaning a lot of capital can’t go near them.

This was all meant to change this year, as Qatar and the UAE had been given a clear indication that if they made certain structural reforms, they would be bumped up to emerging markets, meaning that a lot of fund managers who track the index would have had to put money there – a first step towards a much more investable Middle East. But MSCI has delayed its decision until December 2011, because while both markets did make changes, they have not yet really gone far enough, particularly on foreign ownership limits (still just 25% in Qatar).

LATIN AMERICA

For most investors, Latin America chiefly means Brazil and Mexico. Examples of popular holdings include oil and gas group Petrobras (though it battered investors with a huge rights issue from which the share price has yet to recover), Brazilian mining group Vale (formerly CVRD), the beverage group AmBev (the Latin American arm of Anheuser-Busch), the Brazilian banking group Itau Unibanco (formed in 2008 by two of the country’s biggest banks; its competitor, Banco Bradesco, is also popular), and the Mexican beverage group Fomento Economico Mexicano (also known as FEMSA).

Brazil, Latin America’s representative in BRIC, attracts attention not only because of the outlook for its stocks but its currency and its extremely high rates (12% even after a rate cut). “We would suggest investing in high-yielding countries with solid fundamentals,” says the Blackrock Investment Institute in a study released last month. “In particular, we recommend focusing on countries that offer positive real rates – returns adjusted for inflation. In Latin America, real rates are higher, particularly in Mexico and Brazil.”