Emerging markets - stock markets in countries that have recently industrialised or become free markets - have never been for the faint-hearted investor. The asset class has a well-deserved reputation for spectacular volatility. This was shown most recently when, spooked by turmoil in the United States housing and credit markets, the emerging markets benchmark, the Morgan Stanley Capital International (MSCI) Emerging Markets Index, fell 18 per cent in just 18 days to August 16. But since the Federal Reserve Board cut US interest rates by 50 basis points on August 17, the MSCI Emerging Markets Index has jumped by 26 per cent. The index has surged almost fivefold in a six-year rally.
When emerging markets are going well, they're very good: in 1993, the MSCI Emerging Markets Free Index surged 71 per cent; in 1999, the index jumped by 64 per cent. But when they're bad, they're awful: that lucrative 1999 was preceded by a 28 per cent loss in 1998 and followed by a 32 per cent loss in 2000. More recently, there was the wild ride of 2006, when the index slumped 24 per cent in just three weeks between May and June, only to record a rise of 29 per cent for the calendar year - outperforming both the local and global stock market indices. This volatility is why institutional investors like a dash of emerging markets in their portfolios, because they show little correlation to the developed sharemarkets - and are thus considered capable of adding spice to a portfolio in a lean year.
Since a pivotal report by Goldman Sachs in 2003, the emerging markets sector has been heavily influenced by the acronym Goldman Sachs gave to the big four emerging markets: the BRIC nations, namely Brazil, Russia, China and India. The main emphasis is rightly on the growth engine that is China, but the emerging markets asset class also captures growth in areas of Europe, the developing Association of South-East Asian Nations economies and Latin America - for example, Mexico is often considered the fifth BRIC. More recently, analysts have begun to look at oil-rich economies, such as Saudi Arabia and the Gulf States, and parts of Africa. But emerging markets remains an asset class that is highly vulnerable to investor sentiment in developed nations: hence the battering it took as the US sub-prime-inspired market turmoil turned into fears of a broader credit crunch. While the long-term fundamentals of the emerging markets story remain very attractive, Aberdeen Asset Management associate director Stuart James says the asset class could suffer further from the credit crunch, "if there is more bad news to come out". "The emerging markets aren't directly exposed in the sense that emerging markets banks have any exposure or that there's any credit crunch within emerging markets themselves, but there is real concern that if the US economy slows down - or the US investor becomes spooked - we might see capital flowing back out of the emerging markets and back into the US," James says.
"If there is more bad news to come out - particularly with about US$220 billion in leveraged loans that have to be refinanced - investors are likely to become even more risk averse and emerging markets could suffer. There has been lots of cheap money flowing into emerging markets, and the greater risk is that the emerging markets are very correlated to actual fund flows. The big danger is that investors find themselves having to sell down their emerging markets holdings to pay down debt, or repay their Japanese carry-trades et cetera. The risk is at the finance level, not at an economic level."
While emerging markets are vulnerable to this kind of external shock in the short term, James says the fundamentals of the emerging markets story remain very much intact. "Particularly in terms of Asia, the fundamentals are very strong. There is nothing really wrong in Asia: nations have current account surpluses, companies generally have little debt, the consumer is not highly indebted, there are young populations, there is much more intra-regional trade between Asian countries. From that point of view, there's nothing wrong in Asia: the markets have sold off because of external factors - because of a change in the risk appetites of western investors - rather than something going wrong within Asian economies themselves," he says. While emerging markets are generally moving away from the boom-bust cycle, "you can still get rogue events", he says. "One of the possible sources of rogue events is politics: we can see that in Latin America, with the election of a number of populist governments; and in Russia, where there is a lot of interference from government - company boards are dominated by ex-Communist Party members, and President Putin often uses Russian companies as political tools. I wouldn't paint a glowing picture of all emerging markets - I think generally they have improved, but there are still things that need further improvement. Any of these things could be the catalyst in a future correction, but generally, the fundamentals are much better," he says.
Over the medium to longer term, he says, the fundamentals will still drive the investment into emerging markets. "If there was a short-term correction, and people pulled their money out, emerging markets would simply look even more attractive, compared to their developed world peers," he says. Sovereign Investment Research managing director of specialist alternative investments Ray King says the key remains the US economic situation and the extent to which any slowdown there flows into global investor confidence. "If US growth is hampered, the impact on global markets could be significant. But you can argue that the US is becoming less relevant to the emerging markets - particularly within Asia, which has China now dominating regional trade," King says. "That insulates the Asian emerging markets a bit: in effect, you've got the strength of the China-dependent economies negated a little bit by the problems in the US-dependent economies."
He says investors should distinguish between their Asian and their non-Asian emerging markets exposures. "In Mexico and Latin America, what happens in the US will be very significant for emerging markets. But if you want to talk about what's going to happen in Vietnam, the picture is very different," he says. "Having said that, it's a bit hard to distinguish. Investors generally like their exposure to be through the broader, diversified managers rather than regional or country funds. You can't really have a two-tier approach to emerging markets - it's very hard to differentiate the strategy that far. There isn't the range of funds available." Frontier Investment Consulting managing director Fiona Trafford-Walker says emerging markets is very much an asset class where the investment horizon must be long term. "We think that emerging markets is a long-wave theme that should be in clients' portfolios to take advantage of what's going on in those markets," Trafford-Walker says. "That said, obviously a lot of people have the same view, so emerging markets have performed very well in recent years. We think the prospects for those regions are so strong that you really want to have a pretty solid strategic allocation to emerging markets - probably, to think about whether you want to have a tilt to Asia. We're doing quite a bit of work on how we can capitalise on what's going on in Asia. It's not just equities, but private equity, property, infrastructure - there's lots of ways to play that Asian theme, not just equity markets." At the moment, she says, most Australian institutional investors get exposure by using specialist emerging markets managers, with broadly-mandated funds that cover Europe, Latin America and Africa as well. "But what you will find going forward is that people will start to tilt more towards Asia, as more of a regional exposure," she says.
"In six to 12 months we expect to see more mandates awarded on the basis of Asian focus. I don't think institutional investors will want to use country funds, even a China-focused fund. They will do something a bit more broad - an Asian exposure." Frontier recommends that within the global equity allocation, investors should have at least 10 per cent dedicated to emerging markets. "Some of the broad international market managers may well hold emerging markets allocation, so it would be higher than that. That means that about 3-5 per cent of the fund would be the allocation," Trafford-Walker says.
King expects this allocation to grow as local institutions look to invest in areas such as emerging markets debt and private equity. "A Russian private equity fund is not going to be affected by the US sub-prime mortgage market - there's a range of other things that will drive that kind of exposure. For some, that's going to be an attractive exposure, for that very reason," he says. The changing face of emerging markets
The theory behind investing in emerging markets is that they eventually emerge. One hundred years ago, the United States was an emerging market; 50 years ago, Japan was; 25 years ago, Hong Kong was. The latest candidates to make the jump are Israel, South Korea, South Africa and Taiwan, which account for about half of the MSCI Emerging Markets Index. Israel officially becomes a developed market in June next year, and analysts consider the other three likely to follow within 12 months. The reason emerging markets slumped so dramatically in the wake of financial crises during the 1990s in Asia, Russia, Mexico and Argentina was that they depended on fund inflows from the developed world and were extremely vulnerable to changes in investor sentiment.
This situation has been turned on its head. "From a macro point of view many of the emerging markets are a lot more robust. Globally, emerging markets account for 66 per cent of foreign exchange reserves," Aberdeen Asset Management associate director Stuart James says. "On average, emerging markets are net creditors; it's the developed nations that are net debtors." Globalis Investments portfolio manager Ignacio Sosa says that today, of the 10 countries with the largest foreign exchange reserves, nine are emerging market countries. Globalis Investments manages the Macquarie-Globalis BRIC Advantage Funds. Globalis is a joint venture between Macquarie and Boston-based fund manager OneWorld Investments.
"Many people know that China has over US$1 trillion in reserves, but few realise that Russia has reserves of over $260 billion, Brazil $150 billion, Mexico $97 billion and Thailand $60 billion," Sosa says. "Even Argentina, at the centre of the biggest default in history less than six years ago, has a record-breaking $46 billion in reserves. These are the same countries that had virtually no reserves at all during the panics that afflicted them in the past 15 years." This change has been reflected at company level, too. "Not only have the countries got their national balance sheets in order, but the good companies have also got their balance sheets in order," James says. "Particularly in Asia, net debt/equity ratios are coming down, and free cash flow, dividend payouts, special cash returns, share buybacks and return on equity are all on the rise. All of this works to bring down volatility, although you can't say that's an across-the-board trend." In his book, The Emerging Markets Century, published in January 2007, fund manager Antoine van Agtmael - the man credited with coining the phrase 'emerging markets' 25 years ago - points out that when his firm, Emerging Markets Management, was founded in 1988, there were only 20 emerging market companies with sales revenue of more than US$1 billion, most of them Taiwanese banks or commodity companies.
Today, says van Agtmael, there are more than 270 emerging market companies with over US$1 billion in sales, and 38 with more than US$10 billion. Many of them are high-tech companies or provide consumer products and services. Van Agtmael says many of today's emerging market stars do not rely on cheap labour, abundant natural resources or protective government policies: instead, they have developed competitive advantages in technology, design, logistics and other areas. "More and more emerging markets companies are becoming 'global champions', and that's a process that's only going to continue," James says.
"Look at Samsung and how much of a global company it is. It has ADRs [American depositary receipts, through which foreign companies list on the New York Stock Exchange in US$] and it is as transparent as any other stock in New York. It's not really a South Korean stock any more. "There are plenty of companies like that from the emerging markets, that have global ambitions and are on the way to becoming global leaders. The big Indian outsource companies like Tata Consulting and Satayam certainly look like they want to do that. We're seeing more and more Indian and Chinese companies taking over western companies, and that process should continue."
