Downturn reflects us falls

Decoupling is a word that has been much discussed over the past year. This is the concept that non-US stock markets and economies, particularly those in emerging markets, are able to keep growing if the US suffers a downturn. This has become pertinent with the sub-prime crisis in the US and the volatility that the country’s stock market has suffered since the start of the summer of 2007. While other developed markets also fell along with the US in 2007, initially emerging markets equities did seem to be enjoying a degree of decoupling during the summer. But from mid-October 2007, emerging markets became embroiled in the concerns about future global economic growth and their equities began to suffer steep falls. From 15 October 2007 to 28 January 2008, for example, the MSCI Emerging Markets index fell 15.8 per cent. These falls, however, did follow substantial gains in emerging markets equities over the previous four and a half years. From 6 January 2003 to 7 January 2008, for example, the MSCI Emerging Markets index increased by 231.28 per cent despite a drop of 7.72 per cent from 15 October 2007. Less reliant on us The equity falls of the past few months shows stock markets in emerging markets and developed countries have not decoupled. This is certainly the view of emerging markets fund managers. Claire Simmonds, client portfolio manager of the JPM Emerging Markets Equities fund, says this is partly because of the effect of the economic slow down in the US and other developed countries on exports from emerging markets. Nevertheless, Ms Simmonds says emerging markets are better placed to withstand such a slow down than in the past. Among the reasons for this is the growth in consumer demand within emerging markets, stronger corporate balance sheets and government account surpluses. Such factors have prompted Shaun Jamieson, associate and product specialist of the Merrill LIIF Emerging Markets fund, to say there has been some economic decoupling. “The average current account surplus for emerging markets is 3 per cent of GDP,” says Mr Jamieson. “The G7 countries trail this surplus. According to Citigroup, emerging markets spending on infrastructure up to 2017 is expected to total $12,000bn (e8,200bn). “Even if the Chinese economy slows by 1 per cent or 1.5 per cent this year, growth will still be in double figures.” John Pollen, manager of the Pioneer Funds Emerging Markets Equity fund, says emerging markets have not decoupled but have become less reliant on US economic growth. He likens the Chinese economy to Japan in the 1960s rather than the 1980s, for example. “It is fair to say that China is an engine of economic growth,” says Mr Pollen. “There is more intra-regional trade than in the past. There has also been an increase in exports from Asia to Europe while sales to the US have fallen.” This is reflected in the increasing importance of emerging markets to the global economy. Bob von Rekowsky, manager of the Fidelity Funds Emerging Markets fund, says emerging markets now contribute more than 50 per cent of the world’s GDP. “The increased share of global activity is causing disposable incomes to rise, which is, in turn, creating investment opportunities.” “Companies have the ability to grow their earnings strongly on the back of this increased purchasing power, such as in infrastructure, bank lending, house building and services. When you consider the market capitalisation of emerging markets is still low at over 10 per cent of the world’s stock markets, the size of the investment opportunity in emerging markets becomes even more compelling,” he adds. “A rising share of economic growth and in many cases higher revenues from commodities have allowed governments to rebuild their balance sheets and reduce indebtedness.” Mr von Rekowsky adds that dependence on developed markets and the US in particular is diminishing as emerging markets increase domestic and intra-regional sales. “The secular growth we are seeing in China and India in particular is providing a solid platform for broader emerging markets to move forward. “Better government policy is providing a healthy environment for companies to become more regionally and globally competitive. For example, Mexican company Cemex has grown into a global player in the cement industry with major operations and market share in the US, the UK and Spain.” Global volatility But while emerging markets would continue to grow despite an economic slow down in the US, Mr von Rekowsky says a recession in the world’s largest economy would have a significant negative impact on emerging markets. Mr Jamieson is not surprised by the falls in emerging markets equities over recent months given the global volatility in equities. He says the question is how quickly will emerging markets recover given the general strength of “economic and corporate data”. After all, this is not the first time emerging markets have suffered a correction since the upturn in stock markets began in the spring of 2003. For example, Mr Pollen says there was a correction of 26 per cent in emerging markets in May and June 2006. This was a sharper correction than the fall at the end of 2007 and beginning of 2008. “But in 2006, the correction happened very quickly and then recovered quickly as well.” Indeed, Mr Pollen says he was less concerned about the valuations of emerging markets equities in the summer of 2007 than at the start of 2006. “At the beginning of 2006, valuations had been driven higher after inflows into BRIC [Brazil, Russia, India and China] markets and funds.” Naturally, Mr Pollen says the 15.8 per cent fall in the MSCI Emerging Markets index from mid-October 2007 to the end of January 2008 has created more investment opportunities through leading to cheaper stocks. The Pioneer Funds Emerging Markets Equity fund has been increasing its focus on the Middle East, for example. Mr Pollen says he is intrigued about Saudi Arabia, which he says is the second largest emerging market by capitalisation behind South Korea. But Mr Pollen is cautious about valuations in Brazil. He adds that Russia under-performed other markets in 2007 but did rally in November and December. “This rally was partly because of the liberalisation in gas prices. We have trimmed our exposure to Russia following the rally. This is despite the fact we expect oil prices to remain high, which will benefit the oil sector.” Mr von Rekowsky agrees with other fund managers that it is difficult to generalise about emerging markets and there is differentiation in terms of the attractiveness of valuations. “Certain emerging markets that are trading at 10 to 15 times earnings still offer considerable scope for earnings growth, making them look relatively cheap. I think Brazil, Russia and South Africa are all attractive on this basis.”

‘Even if the Chinese economy slows by 1 per cent or 1.5 per cent this year, growth will still be in double figures’ - Shaun Jamieson, Merrill Lynch	‘The emerging Asia region is the most attractive from an earnings point of view’- Claire Simmonds, JPM	‘Better government policy is providing a healthy environment for companies to become more regionally and globally competetive ’ - Bob von Rekowsky, Fidelity

“China is an example of a market that offers good earnings growth potential but has become very expensive. Chinese stocks look overvalued partly because a lot of money was trapped in the local A shares market, where foreigners are precluded. “Central European economies such as the Czech Republic, Poland and Hungary are starting to look overheated and company valuations offer less scope for upside. Russia has more obvious opportunities for investment with companies benefiting from a positive consumption profile. “The emerging Asia region is the most attractive from an earnings point of view. In Korea, the consumer has been weak but the presidential election could change the dynamic, revealing more domestic demand drivers going forward.” Ms Simmonds says the JPM Emerging Markets Equity fund is managed on a bottom up stock picking basis. Ideas are generated by a team of 50 analysts, who are organised on a country basis, as well as the fund manager. The fund, which holds between 60 and 75 stocks, takes a three to five year view of the value of share prices. Among the characteristics that the fund looks for are stocks with a P/E in line with the index but with a higher return on equity. JPM has a macro economic team that provides views on the outlook for countries and sectors over the next few years, including developed markets. “This leads to a higher or lower conviction for stocks in the portfolio,” says Ms Simmonds. The risk management of the fund analyses the degree of active bets away from the index. For example, if a stock has a 4 per cent weighting in the index and the fund has a 7 per cent allocation, the active bet is 3 per cent. The fund aims to have an active bet of around 65 per cent in total. Ms Simmonds says the fund’s focus on the outlook of stocks over three to five years is reflected in the fact that its relative performance is better over five years than three years and especially one year. Over five years to 7 January 2008, the fund returned 246.41 per cent against 231.28 per cent by MSCI Emerging Markets index. The JPM Emerging Markets Equity fund is the largest emerging markets fund domiciled in Ireland and Luxembourg but Ms Simmonds says the team is comfortable with managing e5.96bn in assets. “This is because we are still finding sufficient investment opportunities. As the fund has grown so has the size of the asset class and liquidity. There was a record number of IPOs in emerging markets last year, for example. “The management of the fund has had to change slightly, such as focusing on mid and large cap stocks. But the fund has always had this bias since launch anyway.” Bottom up approach Mr Jamieson says the Merrill LIIF Emerging Markets fund takes a bottom up approach to selecting stocks with a top down economic overlay. Mr Jamieson, however, says it is not possible to specify the proportion of time attributed to bottom up and top down analysis. It also varies over time. “For example, during the volatility in January 2008, the fund had greater emphasis on top down asset allocation because some countries were more over-sold than other markets,” says Mr Jamieson. “The over-sold markets include parts of the Russian market and Turkey.” The Merrill LIIF Emerging Markets fund is managed out of London and Princeton, US, with the managers supported by nine analysts. The managers and analysts have country specialisations. The only region where analysts are split along sector lines is in Latin America because Brazil constitutes more than 70 per cent of the stock market value in the continent. The initial screening process focuses on liquidity, broker recommendations and other factors. Stock recommendations are debated at a strategy group meeting that is formally held twice a week. The analysts also meet every day to discuss newsflow and stock recommendations. Once recommendations have been agreed at the six-strong strategy group meeting, the emerging markets team meets each of the company’s management. Mr Pollen says the Pioneer Funds Emerging Markets Equity fund also takes a bottom up and top down macro economic approach. The macro economic review is conducted every quarter. Mr Pollen says this usually leads to small amendments in allocations rather than large reallocations. “We spend around three-quarters of our time on bottom up stock selection with the other quarter on macro economic analysis,” says Mr Pollen. “The macro economic analysis includes commodity prices, such as oil. We also look at liquidity provided by central banks and other institutions,” he adds. Mr Pollen says the macro economic analysis is mainly designed as a risk management tool. Countries are given a score of between 6 and -6. Over the past three to four years, no country has had a score below -1. But this analysis can also act as an idea generator. The fund does not look at stocks with a capitalisation of below $750m. The fund avoids stocks that have seen a reduction in earnings in any two years and does not like companies that are over-leveraged. Among the factors the fund considers is the consistency of earnings. Mr Pollen prefers companies with high profit margins and pricing power. But if profit margins are being squeezed then he wants strong growth in sales. If the fund managers are right and economic fundamentals will remain strong in emerging markets then they will not be short of stocks that meet such selection criteria.