Quest for long-term growth

Emerging market stocks rose a record 75 per cent last year as banks in these regions avoided most credit-related losses and investors speculated economic growth would outstrip developed nations. But while emerging markets are still thought to represent excellent opportunities over the mid to long-term, there is uncertainty in the near future.

“Looking ahead, liquidity remains ample and risk appetite healthy, given low interest rates in the developed world,” says Devan Kaloo, head of global emerging markets at Aberdeen Asset Management.

“Emerging markets are thus likely to remain well supported in the short-term, though valuations are starting to appear more expensive. Under these circumstances, we will continue to be vigilant, looking to take profits should valuations move higher.”

Changing circumstances

One concern is that emerging market shares could fall as central banks begin tightening their policies in response to the recovery. They dipped for instance in early January after China’s central bank raised the interest rate on its three-month bills in a bid to curb lending growth.

Interest rates will also rise this year in Brazil, India and other developing countries as policy makers withdraw stimulus measures and look to control inflation during the recovery.

The tremendous run these markets have already enjoyed from their lows in 2008 also limits progress. “Valuations have closed up from the wide gaps at the beginning of the year, and with the possible exception of Turkey and Russia, there will not be significant rerating from here,” says Claire Simmonds, client portfolio manager for emerging market equities at JPMorgan.

However, a certain nervousness about the sector in the short-term is matched by equal optimism about long-term backdrop, namely the urbanisation of a young, well-educated and growing workforce, hungry for all things western. Consumer spending accounts for 60-70 per cent of most countries’ GDP, and China’s headcount is expected to grow by a massive 150 per cent in the next 30 years.

“Of the 6.7bn people in the world, 80 per cent live in emerging markets,” says Nick Price, portfolio manager at Fidelity. “If you take current population growth rates, by 2040 there will be 2bn more people, or 9bn in total, and the vast majority of that growth will be in emerging markets,” he explains.

“There is a direct link between a healthy consumer base and growing GDP,” adds Mr Price. “Japan is the classic posterchild of an ageing demographic. Its elderly are a huge burden on the working population and have a lower propensity to consume. Japan’s systematic failure to recover is a result, and a good route map for where Europe is heading. A high dependency ratio and ageing workforce are very long themes and don’t show up discernibly year to year, but they are still a very important force in the background.”

The growth potential for consumer goods and services is immense, he believes, whether in mobile phones or cement. “If you measure beer consumption in Kenya for example, the beer consumed per head per year is 7 litres compared with 138 litres in Germany. This is the same in every single area of consumption; the poorer countries are still functioning at a basic level,” adds Mr Price.

He cites as an example a foam mattress company in Nigeria, initially spun off from British Foam, which is enjoying sales of 20 per cent plus per year because the rural population is only now switching from mats to foam mattresses.

Stocks that play straight into rising consumer prosperity, such as healthcare, personal care and telecoms, are sought after by most fund managers, with additional value put on companies that make or market repeatable purchases such as soap and toiletries. The credit growth story is a favoured one, as financial services have been oversold along with western banks, and savings rates across these regions are high while the public’s propensity to borrow has not yet been tapped.

Chinese manufacturing

Mobile penetration is no longer quite the universal mantra it once was, as the youngest economies slowly catch up and more mature countries such as Russia, Korea and Taiwan begin to boast a penetration comparable with the developed world.

In terms of tech manufacture, however, most of the world’s supply is now made in China and a handful of other Asian nations. Domestic spending on technology should grow not only from innovations in the consumer market such as the iPhone, e-Reader, Apple Tablet PC, GSP systems and the Nintendo DSi, but from businesses looking to gain productivity and replace existing computers. The average PC in an emerging economy business is estimated to be five years old, compared with the normal 3.5 year life of corporate computers in developed markets. The demands of Windows 7 could also help make it a good year for corporate spending on PCs.

Competetive edge

The increasing competitiveness of the emerging markets in many industries, particularly labour cost advantages, is exerting huge pressure on European manufacturers. Telecoms providers Huawei and Zte Corporation, which facilitate the technology behind mobile phone signals, have mauled companies such as Ericsson and Lucent. Powerstations are typically 30-40 per cent cheaper than their counterparts in the developed world but are also rapidly upgrading to similar levels of quality and service.

Emerging markets can now boast genuine world-beating companies, with returns driven by good, old fashioned earnings growth. “Labour productivity in emerging markets is three to four times higher than in the developed world,” claims Mr Price, “and all the time they are improving their roads, logistics systems, and manufacturing processes. In 2004-8 these countries improved their productivity by around 10 per cent per annum.”

These huge inflows are unlikely to dry up any time soon. “Emerging markets are significantly under represented in world equity markets and most investments are structurally underweight in what is the most interesting investment story of the decade,” adds JPMorgan’s Ms Simmonds.

“A recent article in the Financial Times said the typical asset allocation to emerging markets is just 0.1 per cent of someone’s wealth on average. From 12 per cent of current global equity markets, we believe emerging markets could rise to 42 per cent of global equity markets by 2029,” she explains.

“It is worth recalling they were just 1.6 per cent of global equity markets in 1989. Or, on a pricing parity basis, emerging markets represent 46.3 per cent of global GDP but by 2029 they could represent 67 per cent of global GDP.”

Such rapid growth also brings risks. One of the biggest concerns is the gini coefficient, which measures household income inequality.

“In Europe this is relatively low, although that is sometimes hard to believe, income inequality is much less severe and the political backdrop is stable,” says Mr Price.

“But in some of these emerging economies there are vast differences in wealth, such as for example between the super-rich oligarchs and the average Russian who scrapes by on $5-6,000 (€3,500-4,000) per year. There’s a similar disparity in Brazil and South Africa.”

Political stability remains an issue, legal structures have a way to develop and corruption is commonplace. Industrial sectors with regulatory or pricing issues are more vulnerable to corruption than others.

The structure of local financial markets can also hinder stability. “The asset class remains volatile because first and foremost, there is less of an institutional platform to the base of the markets,” says Ms Simmonds.

“There is less insurance and pensions money under management so these markets will be correspondingly more greatly influenced by the exiting of foreign capital and by local investor speculation,” she explains.

“There is also a high commodity weighting in the indices, particularly countries such as Russia and Brazil, which brings with it higher volatility,” adds Ms Simmonds.

The main risks to emerging markets are no longer domestic issues but external macro ones. Balance sheets are also in a healthy state, in general better than the developed world. Russia, for instance, now has $400bn of reserves.

“We talk of political risk in emerging economies but there may now be more of a risk in developed markets than in emerging ones if you think for example of political interference in the financial sector,” says Wim-Hein Pals, head of emerging markets equities at Robeco.

Many fund managers prefer China, India and Indonesia which are at an earlier stage in economic development than, say, Korea and Taiwan. Brazil, an obvious example of a success story, splits opinion. Some have taken money off the table in anticipation of an election year, while others talk of its more stable business cycle.

Investors still underweight but attitudes changing

Forecasts for emerging market equity returns range from single digits to as much as the 20 per cent suggested by Morgan Stanley, but almost everyone is agreed they will outperform developed nations.

“China and India are expected to lead the way with growth of around 10 percent and 7 percent respectively, with the Chinese consumer expected to fuel domestic growth,” predicts Bill O’Neill, portfolio strategist, Merrill Lynch Wealth Management Emea.

“Central banks are forecast to increase their focus on inflation in 2010, with India, Korea and Indonesia among countries expected to raise rates in the first half of the year. China and the eurozone are expected to follow suit by the end of the year. But the threat from underlying inflation is likely to remain muted.”

Paul Gibney, partner at Lane, Clark & Peacock, who forecasts a return of 10 per cent per annum, says: “My concern is that all the good news may now be priced in. Emerging markets are doing what we said they would do. But while they were very cheap a short time ago, they’ve had a good run and some may even think they are in bubble territory.”

Attitudes to the asset class have changed in a subtle way, however. “Traditionally emerging market stocks have been only a modest exposure in portfolios, and one that over extended periods delivered a high level of volatility but not much of a return,” adds Mr Gibney.

“That is changing as the foundations are now in place for expectations that returns can and will be delivered. Generally, these economies were started by exports but the focus has switched to domestic growth, and local governments are not labouring under huge deficits and all those other drawbacks of developed markets such as consumer debt,” he explains.

Most investors are underweight this asset class, but that is expected to change, and as the market develops, fund ranges are becoming more specialised and targeted. For example, JPMorgan’s emerging market range includes value and growth funds, and a total return fund (EM Alpha Plus), a relatively new concept in this space using the Ucits III framework.

“Investors need a more nuanced approach, for example core and satellite funds,” says Claire Simmonds, client portfolio manager for EM equities at JPMorgan. “That might be by value, market cap, regional preferences or express views.”

The long-established Capital International fund invests in smaller companies from $200m (€138m), partly a result of the equity team working alongside private equity and debt specialists. Suzanne Hutchins, investment specialist at Capital, says six equity researchers travel around with the group’s bond researchers and consequently gain an insight into certain smaller companies. This boosts the fund’s holdings in small caps in the healthcare and consumer markets which are underrepresented in the index.

Nick Price,

Fidelity