Emerging markets - the road not taken
Although experts predict a good year for emerging markets, some regions – like Europe – should be avoided. However, it is always important to stay ahead of the curve, writes Janine Mace.
Everybody knows the story about emerging market investments – huge natural resources, expanding populations, youthful demographics and strong economic growth.
But just as everyone knows the story, they also know that investing in emerging markets takes a strong stomach prepared to endure the seemingly eternal boom/bust cycle characterising their performance.
It’s a cycle that saw emerging markets boom in 2009, only to slump again in 2011 as investors shunned anything viewed as vaguely risky.
The so-called ‘risk-on/risk-off’ pattern saw global fund flows into emerging market equities decline 4.2 per cent in the third quarter of the year after dropping 1.4 per cent in the previous quarter, according to HSBC's Fund Managers’ Survey of 13 of the world’s leading investment management houses.
“The survey results are no surprise as there is very high market risk aversion due to European and US concerns. It is no surprise that quarter-to-quarter managers are changing positions,” explains Geoffrey Pidgeon, head of global investments for HSBC in Australia.
However, the recent fund outflows do not paint the whole picture, with many investors staying positive on emerging markets and particularly China, according to Michael Collins, an investment commentator with Fidelity Australia.
“The world economy is not in great shape, but emerging markets are in quite good shape. They will be affected by a recession in Europe, but the past decade of growth has set them up for the next decade of growth,” he explains.
This view is supported by the IMF’s World Economic Outlook September 2011, which predicts emerging and developing markets will grow 6.1 per cent in 2012 (compared to 1.9 per cent for the advanced economies). Collins also notes the IMF is predicting growth of 5 per cent plus for the next five years.
“Emerging markets have a good economic outlook and over time people will gain greater confidence in the performance of their stock markets,” he says.
“The outlook is reasonably optimistic over the next five years and robust over the next 12-18 months, but they will still have challenges.”
Europe remains the problem
Although many experts believe the outlook for both emerging market equities and bonds is good, they all caution this is dependent on what happens in Europe, as the performance of these economies remains linked to global growth.
“All the demographic reasons and issues such as developed market debt-to-GDP [gross domestic product] being higher and the greater accommodative position of emerging market banks bode well for emerging markets – if there is no global slowdown,” Pidgeon says.
The uncertainty about Europe is clearly having an impact, he notes. “The market is trading for two different outcomes at the moment.
The first is the world economy surprises on the downside and there is a synchronised European recession – which we don’t buy. The second is there is no synchronised global recession and growth starts to improve and there is no recession in Europe. This is the HSBC view.”
The European uncertainty means the performance of the US economy and the approach of the Chinese Government are vital, according to Diane Lin, senior portfolio manager for Pengana Capital's Asian Equities Fund.
“Europe is the biggest risk and it is unlikely to have strong growth as the governments there are unable to stimulate their economies. If they do not handle things well, we could see a sharp downturn in the first six months. For the whole year, Europe remains likely to experience low growth,” she explains.
“In the US, the economy has overcome the worst problems but we will not see substantial growth. We will see stable, but not strong, growth of around 2 per cent.
“All this leads to China being very important in the whole picture. China is a very export-directed economy, but its biggest markets are likely to experience slow growth, so the role of the Chinese Government is incredibly important.”
Pidgeon agrees, but believes there is much to be positive about. “It is not all bad economic news and the US recession risk seems lower. In China, the fear of a hard landing is overrated and policymakers are reacting positively,” he says.
“A lot of developed markets have an accommodative monetary policy and when this happens, you typically see emerging markets rebound.”
Catching the upswing
The potential for a rapid rebound is a key factor in the current appeal of emerging markets.
Lonsec senior investment analyst Steven Sweeney points to the dramatic movements in these markets when investor sentiment changes. “Emerging market history is that when sentiment is clouded, they are seen as a risk-on investment,” he explains.
“You need to be cautious, but if we see improving global conditions, then sentiment can turn quickly.”
The prospects for global growth are critical to the performance of emerging markets, as most of these economies are closely tied to resources.
“We have seen how they can turn very quickly. While 2008 was disappointing for emerging market investors as capital flowed out quickly, in 2009 Asia was the fastest market to rebound – so you don’t want to be trying to time it,” Sweeney cautions.
“We believe it is prudent to maintain a cautious view on emerging markets at the moment; however, it is worthwhile maintaining some exposure. But now is not the time for a rapid rise in portfolio exposure.”
Pidgeon believes emerging markets will rebound again this year. “In 2012 we believe we will see double-digit returns in the second half of the year based on a reversal of European concerns and a realisation the market is oversold and developed market concerns are overplayed.”
He believes investors need to consider the fundamentals and look beyond current market concerns.
“Emerging markets remain hostage to European turbulence and China, so they will have a tough six months. However, as medium-term investors, we find pockets of value and continued growth despite the outlook at the moment,” Pidgeon says.
“It is fair bet that in 2012 people will think the worst is over and all the bad news is factored in. That is when money will be made, as emerging markets will rebound.”
Another factor supporting a positive view towards emerging markets is some very attractive valuations. “Emerging market valuations are at a historic low, with forward PEs of 9.5 times, which is a 15 per cent discount to developed markets,” Pidgeon notes.
Sweeney agrees valuations are good. “The sell-off over the past year presents an opportunity if you can block out the macro and focus on the fundamentals. Valuations are very attractive at the moment with less than 10 times PE when the long-term average is 13 times.
"So it can be seen as a great long-term opportunity; however, it could fall further if European concerns continue,” he says.
Cheap valuations aside, many emerging market companies are also attractive investments. “These are good stocks and they are companies that are worth owning,” Collins notes.
Despite the opportunities, Sweeney believes advisers need to tread carefully. “It is very difficult to weigh up the risks and returns, but you need to look at the way the global economy is moving and look at which markets you want exposure to over 20-plus years. GEMs [global equity markets] have delivered better returns, but the trade-off is higher volatility,” he says.
To support his point, Sweeney cites the 2011 performance of emerging markets (which were down 18 per cent), compared to developed markets (down 12 per cent).
“The rewards are greater, but there will be years where you will feel more pain. If you have the stomach for the volatility, then you should have emerging markets exposure.”
Although this volatility has always been an issue for emerging market investors, the increasing inflow of institutional money is expected to dampen this trend.
“As institutional investors now have to have emerging markets exposure in their portfolio for benchmark purposes, we should see less volatility,” Sweeney argues.
Investors are Asia-bound
While China has been the most popular emerging market in recent times, other countries are starting to win admirers.
“Russia, South Korea and Turkey are the most attractive at the moment. South Korea has a 12.5 per cent forward ROE [return on equity] and Turkey’s is 16.2 per cent,” Pidgeon says.
“In Russia we are overweight cyclicals – especially energy. This is our largest overweight relative to benchmark as it has a forward ROE of 17 per cent. Russia usually trades at a discount to other emerging markets, but despite that we believe this discount is too high.”
Collins agrees there are interesting opportunities outside China and is also a fan of South Korea, although he is attracted to some of the Southern Asian nations.
“Within Asia, Indonesia is an interesting case as it has had the best-performing stock market. Indonesia is now a democracy with a local demand-driven economy, not an export-driven economy like China.
"It has good economic fundamentals and has regular debt rating upgrades versus Europe’s downgrades,” he notes.
Sweeney agrees: “Indonesia can be seen as a strong 10-year story. It is a small component of the index, but it is expected to grow.”
In Lin’s view, several Asian markets are appealing, particularly those with governments in a position to stimulate their local economy.
“You need to look at whether policymakers have room to implement stimulatory policy in their local economy,” she says.
Stock values are also important. “Generally we are positive on Asia (particularly China and Japan) due to their valuations, but not so much the ASEAN [Association of Southeast Asian Nations] markets.
"Indonesia and Malaysia have been good performers, but currently are quite expensive and overvalued, we believe.”
When it comes to the BRIC (Brazil, Russia, India and China) economies, it seems interest is on the wane.
“BRIC was really the flavour of the month five years ago, but there has been a 23 per cent drop in the BRIC index this year,” Sweeney says.
He sees problems with the economies of several BRIC countries. “Russia is tied to the oil price, the rouble is correcting and the political situation is making the outlook cloudy.
"The BRIC story is really China and India and with that you are getting Asian exposure, but not exposure to emerging Asia, which has the good performers such as Indonesia.”
Enthusiasm for the BRIC theme is also lukewarm over at HSBC. “The BRIC economies have struggled in 2011 due to fears about growth slowing and concerns about high inflation,” Pidgeon says.
“We are underweight Brazil and India due to their expensive valuations and the uncertainties due to the high and stubborn inflation in India.”
Essential part of the portfolio
Although there is debate over the most attractive emerging markets and whether now is the right time to take advantage of cheap valuations, one point is not in contention – whether these assets belong in an Australian investor’s portfolio.
“Most people should have an allocation to emerging markets to take advantage of the long-term growth story and this has not changed despite the recent declines,” Pidgeon argues.
“Emerging markets to us represent great value and advisers should be looking to the medium-term and be including them in the asset allocation.”
Collins agrees: “With emerging markets it is well worth including some exposure in a diversified portfolio.”
According to Sweeney, this debate is finished among institutional investors, and the retail market is only now catching up.
“There is good institutional interest, but retail is trailing that trend. Most institutional investors have a 5-10 per cent asset allocation, while for retail investors it is less than 5 per cent. As institutional investment increases, it becomes more compelling for retail to keep up,” he explains.
Pidgeon believes retail investors need to make a meaningful allocation to gain exposure to the growth potential of these countries.
“We believe 15-25 per cent of the total global equities basket should be in emerging markets, which leads to 5-10 per cent of the total allocation.”
According to Sweeney, the right allocation depends on the particular investor and their other investments.
“Lonsec believes you need to have some exposure to emerging markets (10-20 per cent of the global equities allocation), but investors need to be aware that they may already have exposure through their global managers, so they need to check the investment mandate.”
Collins believes the right allocation depends on the risk tolerance of the individual investor. “I believe emerging markets have a great long-term outlook and that will not be torpedoed by what happens in Europe. These economies have enough local demand to drive long-term growth.”
He points out emerging markets produce 40 per cent of the world’s exports, but currently represent less than 15 per cent of the world’s market cap.
“This will only increase, so you need to get in ahead of that, as that is where you make money – being ahead of the curve.”
In the future, Sweeney expects emerging market investments to become mainstream, with the action shifting further afield. “Frontier markets may be the thing when you want to add some spice to the portfolio,” he predicts.
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