Opening the back door to emerging market growth

The higher levels of growth in emerging economies, especially those in Asia, when compared to the developed world, offer a range of opportunities for private investors. High valuations of Asian stocks, however, along with possible risks of inflation in the region mean many of the best opportunities for accessing this growth may well be found in global companies deriving increasing profits from emerging markets, rather than Asian companies themselves.

“The emerging world recovery has been truly extraordinary; a classic V shape,” says Guy Monson, CIO and managing partner of Swiss bank-owned Sarasin & Partners in London. “We owe a lot of it to the Chinese fiscal programme, which is what I think will be probably regarded as the largest fiscal stimulus per unit of GDP outside wartime in history. But all of this comes at a cost of rising inflationary pressures.”

Guangdong, the export heart of China, recently raised its minimum wage by 20 per cent, while headline inflation in India has risen to 16 per cent, a level Prime Minister Singh described as deeply worrying, says Mr Monson. Vietnamese inflation has doubled to 8.5 per cent in just seven months.

Tighter fiscal policy required

These developments point towards a need for tighter fiscal policy across the emerging markets, he believes, although many governments will find this hard to execute unless the US raises interest rates first, which looks unlikely in the foreseeable future.

Mr Monson highlights reports of rising living costs and increasing labour shortages in China, along with big rises in food prices as government subsidies are being removed, particularly in India. Valuations in these markets are now on the high side, he adds.

“I think that we have got a relatively classic asset price bubble emerging in this recovery, and that you have got one of these windows that last occurred in 95-96-97, in the run-up to the Asia crisis, when you make more money, are subjected to lower volatility, and probably have got greater transparency by investing in the Western blue chips selling into Asia, rather than in the Asian markets themselves.”

Sarasin favours a “nifty fifty” theme in a global equities portfolio, referring to the informal term used to refer to 50 popular large cap stocks on the New York Stock Exchange in the 1960s and 1970s, that were widely regarded as solid growth stocks. But this time the theme would be played out on a on a global, rather than solely US, scale.

“If you go back to the late 50s and early sixties when the phrase was coined, it wasn’t just the fifty largest companies in America, it was the fifty largest companies with a broadly global distribution base, and a broadly non-cyclical, more growth orientated, business model,” comments Mr Monson. “That is, I think, what you want today, and we would select those funds through our thematic equity investments, and we would recommend a large, fat, global theme fund, which would gain you a lot of the dynamism of the Asia region, but solve the valuation, balance sheet, and interest rate problems which you have in a local market.”

Priya Kodeeswaran, who manages the RWC Advance Absolute Alpha Fund, a global long-short equity absolute return fund launched in February this year, agrees with the theory of focusing on global sectors and companies to take advantage of value shifts across regions. “By having a global approach, we can objectively identify winners and losers on a international basis regardless of domicile,” says Mr Kodeeswaran.

This is especially relevant in those industries and sectors which are truly global from both a competitive point of view as well as end market demand potential. “Again, we follow the value transfer rather than being tied into investing into a specific region,” he adds, acknowledging that following Western companies into Asia is an effective way to generate returns. “For a large amount of Western, developed companies that are smart and can sense the opportunities, they can still make money out of Asia by tilting their business to where the growth is, and those are the companies that I look to play in the US and Europe. It’s not as if it is all going to go one way, that Asia is going to expand and the West will be left for dead, but there are going to be winners and losers, and companies that get it, and those that don’t.”

Local expertise

In choosing which companies are likely to do well in Asia, local knowledge is imperative, believes Wilfred Sit, head of investment strategy for Korean emerging markets specialists Mirae Asset Global Investments. “It is unlike investing in developed markets, such as the US or Europe, where the industrial structure is quite stable and after years of competition you have only a few survivors,” he says. “When it comes to emerging markets, given that things are still relatively new and fluid, it requires more bottom-up research on company structure, as well as the company’s growth itself, to see if they will benefit from the changing world. You need local expertise.”

A fund focused entirely on emerging markets will offer a more direct approach, but a global fund gives diversified access for investors, with some exposure to emerging markets, believes Mr Sit, who is based in Hong Kong. However this indirect approach, which would cater for those with lower risk appetites, may suffer from transparency issues. “You would have to look a lot deeper to figure out what these companies exposure to emerging markets really is,” he explains.

Global funds are not necessarily the best way to approach investing in emerging markets, according to Roberta Gamba head of portfolio construction at JPMorgan Private Bank. “Our approach is to build regional equity exposure based on the market outlook for each region,” she explains. “This implies that we would not necessarily use global funds in building a global equity portfolio because they would not necessarily represent our outlook per region. We want to own the decision of how much to invest in the US, Europe and in Asia.”

Consequently, JPMorgan would use funds dedicated 100 per cent to a specific region to get the required exposure, says Ms Gamba. While her expectations for Asia and emerging markets in general is that they are set to produce higher performance than developed markets, these returns will come with higher volatility, she warns. “Accordingly we would not suggest investing an entire equity portfolio in Asia/emerging markets just because over the long term they can potentially deliver better performance,” says Ms Gamba, highlighting the importance of private investors having a portfolio diversified across different regions in order to manage risk.

“Moreover, a global equity portfolio allows us to take advantage of short-term opportunities in a variety of markets which would not be achievable with a 100 per cent emerging market portfolio,” she adds.

JPMorgan believes in a top down approach to investing, with a bottom up overlay. “Fundamentally we want the macro story to support a specific region to allocate in, but there may be exceptions; such as a specific manager able to generate alpha via stock selection,” says Ms Gamba, revealing a current overweight allocation to Asia/emerging markets, a neutral US equities position and underweightings for Europe and Japan.

These positions are implemented through a mix between active strategies, passive managers and structured products, she says, with ETFs or structured products favoured if alpha is scarce, and active managers otherwise.

Passive risk

The volatility and risks involved in investing in emerging markets mean a passive approach to investments, for example by going down the ETF route, is a risky tactic, according to Jerome Booth, head of research at Ashmore Investment Management.

“I would say that, generally, ETFs are a second best option. Often a benchmark is much riskier than an actively managed portfolio, and that is very much the case in emerging markets, both debt and equity,” he explains.

“Basically, a lot of the big macro-risks are very easy to see coming. A country does not default, or have a major devaluation, without having a clearly identifiable problem, months in advance, that anybody can see coming. Now if they want to stay invested in it because they are getting huge returns then that is one thing, but the prudent investor can very easily get out of, for example, Argentina, before 2001, which was probably the easiest call in the history of emerging markets. But the point is that that was 25 per cent of one of the debt indices.”

The passive investor takes an enormous amount of concentration risk, in particular in emerging markets, where there is big macro risk, believes Mr Booth. “An ETF is basically a very risky strategy compared to a well-managed active portfolio. And for what? What added benefit is there? I can’t see it. Active management can not only add return, it can reduce risk.”

The risks involved in building a real estate portfolio

Real estate is an asset class likely to benefit from the increasingly domestic-driven growth within Asia’s emerging markets, and can offer private investors opportunities for diversification. “Investors, generally speaking, are massively underweight emerging markets, but they also need ways in which to invest away from the traditional equity,” says Jerome Booth, head of research at Ashmore Investment Management.

Countries looking to boost domestic consumption can turn to construction, both in real estate and in infrastructure, though he feels the latter is more attractive. “I expect infrastructure booms in a whole range of countries, with India being top of my list, and even if a country cannot invest in infrastructure itself very easily, it can invest in other countries, which would be much safer for them than investing in Europe and the US.”

One of the attractive factors about Asian real estate over the long-term is that it tends to appreciate in line with countries’ superior economic and income growth, believes Ivan Leung, chief investment strategist for JPMorgan Private Bank in Asia.

“However, the region is very heterogeneous and the top three rules for investing in property are: location, location and location. Selection of country, city and block can offer very different prospects,” he warns. “Asia tends to have more extreme boom-busts than developed markets. As such, entry levels and timing are more crucial. For many markets like China tier-1 cities, Hong Kong and Singapore, residential properties have appreciated substantially in 2009 and are generally considered to be expensive. Therefore our advice is to focus on US distressed real estate, as the entry levels there are far more opportunistic.”

Real estate is also less liquid than equities and investors are therefore more likely to be tied in for longer periods, says Wilfred Sit, head of investment strategy for Mirae Asset Global Investments. Real estate is also subject to political interference, he explains. “Asian governments in general are very cautious about the formation of asset bubbles in the property sector, because of the property bubble preceding the Asian financial crisis in the late 90s.”

Governments can look towards both the US and in Europe, where the financial crisis was led by the formation of property bubbles, he adds. “The Asian governments want to protect consumers from encountering the same kind of bubbles, and would enforce the necessary policies if they saw any sign of that happening,” says Mr Sit.

Guy Monson, Sarasin & Partners