Should investors favour exposure to developed or emerging markets?

Emerging markets

Chris Godding

EMEA Chief Investment Officer, Morgan Stanley Private Wealth Management

The Asian Financial crisis of 1997 put many emerging country economies on a path to weather the later financial crisis in 2008. Post 1997, the terms of trade adjusted in favour of developing nations and many emerging countries rebuilt foreign reserves to ensure future stability.

Financial institutions were also naturally wary of the leveraged finance model, exploited through Europe and the US in the last decade. Financial stability and fiscal health is, therefore, a principle building block of the emerging market (EM) theme and the financial crisis of 2008 divides the world pretty clearly in favour of developing versus developed. Current account balances also indicate that the terms of trade still favour emerging countries and that the much vaunted global rebalancing shows scant evidence of making meaningful progress.

A longer term, but possibly more powerful, demographic theme accompanies strong balance sheets and exports.

The transfer of wealth from developed to emerging markets and self-sustained growth are both driving the expansion of the EM middle class population. This theme will be sustainable and persistent because of productivity potential in terms of both capital investment and labour.

Changes in productivity through policy, demographics or technology are extremely powerful drivers in terms of the pace of economic development. In many developing economies, enormous opportunities for capital investment exist that promise a continuation of the productivity miracle for some time to come. In addition to capital investment growth, the labour productivity ratios in the less developed nations have a much rosier outlook than those in their developed peers.

The sad truth is that by 2050, there will be more pensioners than workers in developed nations as the productivity ratio* between those ion their economic prime and those in retirement falls to as low as 0.91. By contrast, the productivity ratio in emerging countries in 1970 was 4.73. In 2010, it was 4.14 and in 2020, it will be 3.84.

A structurally productive workforce is a key aspect of the long-term growth potential for emerging economies and particularly their performance relative to the developed world.

On a country basis, we are becoming more positive on two of the highest weighted regions in the EM index, China, and Brazil. In China, we expect the CPI to peak in the second quarter and this should signal the end of the tightening cycle. Loan growth will improve if monetary conditions ease and is positively correlated to the performance of China “A” shares. China’s “A” shares are trading at near record discount to the Hong Kong listed “H” shares and the market P/E is 26 per cent cheap relative to the 5-year average.

Brazil’s restrictive fiscal policies have been a drag on the market recently. Significant dilution from new issues in 2010 was also an issue. We expect the bulk of new equity issuance is now behind us and are beginning to see an improvement in the economic data relative to expectations.

The recent rise in oil prices is also a significant positive for Petrobras in Brazil and for markets such as Malaysia, Mexico and Russia. The case for Central and Eastern Europe is improving as manufacturing exports recover and this is the cheapest sub-region of the index.

Thematic investing is dangerous if investors forget about valuation. Emerging markets today are trading in line with the five-year average and in no way comparable to the thematic bubbles of the past, such as technology in 2000. Earnings are vulnerable to negative revisions from input costs and central banks in certain countries have more work to do to control inflation. However, in the context of the next 20 years, trying to finesse the entry point is a futile effort.

Client portfolios at Morgan Stanley PWM generally have 13 per cent of equity portfolios and 16 per cent of debt portfolios invested in emerging markets. The equity allocation is low relative to our position over the last year, due to short-term concerns regarding the central bank tightening and investor exuberance but we are looking to take advantage of the recent weakness to increase exposure.

*From the Golden to the Grey Age: Long term asset return study, Jim Reid, Deutsche Bank Securities

Developed markets

Paul Marson

Chief Investment Officer, Lombard Odier Private Bank

The heady mix of a 156 per cent rally since 2008 and powerful economic growth has created an aura of excitement around emerging market equities. Sure, emerging markets have rewarded investors handsomely in recent years. But on current valuations and earnings growth prospects the best opportunities are now to be found in developed markets.

Among the developed markets, we currently prefer Italy, Japan, and Germany. Italy and Japan, in particular, are notably cheap. On a price to trailing 10 years earnings basis, Italy is trading at a ratio of 10.9 times, 63 per cent below its average since 1984. Although Germany is only 20 per cent below its long-term average since 1970, its growth and strong momentum are appealing to investors.

Alongside valuation, an important factor in returns is the implied equity risk premium. This is the implied return, from current valuation, offered above the risk free rate (ie from government bonds) as an incentive to take risk, and provides a measure of the margin of safety or probability of loss inherent in the current valuation. Italy tops the table with an equity risk premium of 13.2 per cent. Spain, with 10.7 per cent, and the UK, with 11.4 per cent, also present good value. In contrast, Indian equities have an equity risk premium of 2.8 per cent, offering investors little incentive to take risk.

Developed market equities are also supported by the macroeconomic environment. As food and oil prices surge, inflationary pressures could lead developed markets to perform better over the short and medium term. Emerging countries are more sensitive to commodity price moves than developed markets, as commodities account for a higher proportion of their consumer spending. Food accounts for 15 per cent of the consumer price index in developed countries, compared to 35 per cent in emerging countries.

Governments in emerging countries will fight inflation by raising interest rates and contracting monetary policy. Developed markets could as well tighten monetary conditions (especially with QE 2 ending in June), but on a relative basis, monetary conditions will remain looser for longer compared to emerging markets. This adds to the incentive for investors to rotate away from emerging market bonds and equities in favour of developed market assets.

Much has been written about the emerging markets growth miracle. Miraculous or not, investors should remember that economic growth has little to do with equity returns – there is no correlation between the two. The important factors are not growth itself, but growth per capita, or earnings per share. Although there are good investment opportunities in high growth countries, economic growth should not be the reason to choose a specific market. Still less should low growth be a reason to avoid countries that are cheap, as Japan and some Continental European markets are today.

We believe the best way to grow and preserve wealth through market cycles is not to play the bubble game, but to buy cheap assets with a healthy implicit margin of safety. The best place to find those assets today is in developed markets.