Emerging markets offer attractive investment opportunities, but opportunity comes with risk, as Lisa Pennell reports.
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Emerging markets could well be described as the wild card in the deck of international investment options. Including the regions of South America, Latin America, Eastern Europe and much of South East Asia (excluding Japan), the term is used to describe developing countries that are industrialising at a fast pace. Emerging markets (EMs) are exciting to investors, offering high potential gains over the medium to long term. Few EMs offer significantly higher yields than developed markets – it’s all about the potential for capital growth. The flipside to the possibility of superior returns is that EMs are volatile and carry high risks for investors, particularly in the short term.
Typically, EM economies feature relatively low levels of income per capita, but have the potential to significantly increase the level over time. To qualify as an EM from an investment perspective, they must also have a local stockmarket that is available to foreigners for investment. The biggest and fastest growing countries in the EM category that have attracted the bulk of investor attention over recent years are Brazil, Russia, India and China – also known as the BRIC economies. Along with these, there are opportunities in less prominent but also promising countries, including Thailand, Hong Kong, Taiwan, Malaysia and Korea. Between 2003 and 2007, EM funds outpaced most other types of managed funds with a healthy rate of growth; but the unfolding global financial crisis (GFC) served to highlight intrinsic risks and volatility.
‘Volatility is exactly what makes these regions attractive to long-term investors’
EM share prices were hit harder than those in developed markets, with the MSCI Emerging Markets Index plummeting by more than 40 per cent in $A terms in 2008. This drop was significantly more than falls in the MSCI World index and the S&P/ASX200 Accumulation Index of Australian shares. But rather than serving as a warning to avoid EMs, the trend of volatility is exactly what makes these regions attractive to long-term investors with an appetite for risk.
Post GFC, EMs recovered earlier and more strongly than developed markets, mainly due to their match fitness when the crisis began. Most of the EM countries had built up reserves pre-GFC that they were quickly able to draw on; and they also had low levels of debt – both of which insulated those economies from the more serious effects of the crisis suffered in many developed markets.
Nader Naeimi, senior investment strategist for AMP Capital, says EMs had the will and resources to provide stimulus to their economies without incurring the levels of sovereign debt that the US, UK and Europe have.
“Many EMs still have significant resources, are still in surplus and are able to continue to stimulate their economies. It’s a global rebalancing – the emerging world has all the dynamics of growth with a good combination of external and domestic demand,” Naeimi says.
“The exception is Eastern Europe, which is still quite vulnerable.”
And the official statistics support this. In the most recent World Economic Outlook released in July 2010, the International Monetary Fund (IMF) showed that while advanced economies grew by just 0.5 per cent in 2008 and contracted by 3.2 per cent in 2009, emerging/developing economies grew by 6.1 per cent and 2.5 per cent, respectively, during the same periods.
Going forward, the IMF has predicted that growth in emerging economies will continue to far outpace that of developed economies in the near term. In 2010, advanced economies are projected to grow by 2.6 per cent, dropping slightly to 2.4 per cent in 2011, while emerging and developing economies are slated to grow by 6.8 per cent this year and 6.4 per cent in 2011. These figures hide quite large variations within each of the categories.
For example, while the UK is projected to grow by just 1.2 per cent in 2010 and 2.1 per cent in 2011, China is projected to grow by 10.5 per cent and 9.6 per cent over the same periods. Other high EM performers include India at 9.4 per cent in 2010 and 8.4 per cent in 2011; and Brazil at 7.1 per cent and 4.2 per cent, respectively.
Outside of short-term projections of growth, David Urquhart, portfolio manager of the Fidelity Asia Fund, points to other compelling factors which suggest further outperformance in the future for EMs. One is the sheer size of the opportunity – around two-thirds of the world’s population live in EMs. He says 20 years ago, 70 per cent of the world’s growth was generated by developed economies and nearly a third of this by the US alone. Today, EMs now account for almost three-quarters of global economic growth.
“A comparison of the developed and emerging worlds shows clearly where the potential growth is to be found. The size of EM economies per head of population is still a fraction of the equivalent measure in places like Japan, Germany and the UK. In Japan for example, GDP per capita stands at $44,000, while in China it is still less than $4450,” Urquhart says.
“In 2000, developing countries were home to 56 per cent of the global middle class, but by 2030 that figure is expected to reach 93 per cent. An increasing middle class means an increase in the associated demand for goods and services, as well as increasing political stability.
“Additionally, credit ratings have been slashed among some Southern European countries of late, while at the same time these rating houses have been boosting outlooks for Asian countries, including India, Indonesia, South Korea and the Philippines.”
Urquhart points out that another positive side effect of the GFC for EMs, particularly in Asia, was the opportunity to expand market share in developed markets, due to cost-consciousness fuelled by the troubled times. “During the crisis, brands like Acer, Hyundai, Samsung and LG became more attractive to consumers who were looking for good value for money.
So even though total consumption declined, the market share of some Asian brands was increasing, resulting in a stable or even growing performance for those businesses.”
Urquhart adds that local EM brands often have more success expanding in their own local markets than in developed markets, so investing directly in EMs can be more effective than via multinationals with EM exposure.
“EMs are generally looking for a lower price point for products. It’s much easier for a local company in that market to provide that product, then add features to suit developed markets, than the other way around.
“Also, those local businesses will not have the drag common to businesses which have the bulk of their enterprise based in the slower growing, developed markets.
