Should we still consider emerging markets?
A continued upward trend? In the face of the recent market correction in developed markets, investors may well be considering tempering their attitude towards risk and diversifying away from holding investments at the higher end of the risk spectrum. But should we be so hasty? If we stick with a range of equities from different geographies and sectors are there still opportunities to be found which may deliver upside potential? As we all know, emerging markets have delivered very attractive returns in the last few years. The MSCI Emerging Markets Free (EMF) Index returned over 30 per cent in both 2005 and 2006, compared to 10 and 20 per cent respectively for the MSCI World1. Do the prospects for 2007 look as good?
Fresh opportunities abound We believe that emerging market equities as an asset class continue to offer opportunities in 2007 for growth commensurate with a predicted 10-12 per cent earnings growth and a 3 per cent dividend yield2. Barring a bout of serious over-investment, we believe that the secular growth opportunities that abound in the emerging world, coupled with the ability of improved corporates to execute on this growth, should continue to drive margin expansion and grow emerging market earnings. Historically, the fate of emerging market economies performance was closely related to the US interest rate. However this is increasingly less the case in the face of strengthening fundamentals in the developing countries’ markets. There is potentially therefore a case for holding emerging markets, not just for their alpha potential but also as a diversifier from developed market equities. There are several factors behind this optimistic view which make for a strong investment rationale. Firstly, secular growth trends, such as increased infrastructure spending and the emergence of domestic consumers. As economies expand in the developing world and countries experience growing urbanisation it appears that infrastructure is being invested in to support this expansion. The commodity consumption which is related to infrastructure spending should enable commodity pricing to remain robust in 2007. In addition, attractive demographics (higher working age populations relative to developed markets) and real wage growth are supporting the emergence of a middle class and by extension, the domestic consumer. This should mean that emerging economies are no longer as reliant upon exports for growth. Secondly, we expect emerging market companies in general to capitalise on these secular growth opportunities through a more efficient use of their balance sheets in 2007. Emerging market companies seem to have used the recent structural decline in interest rates to deleverage to historically low levels; half that of their developed market peers. This is particularly impressive when viewed in the context of the increasing profitability (ie higher return on equity) that seems to have been achieved not at the expense of, but in spite of lower leverage levels. Reductions in real interest rates and increased access to international capital markets should allow companies from the emerging economies to take on more leverage in order to better exploit growth opportunities and further enhance profitability. Meaningful growth In summary, it looks like this asset class is not priced for “perfection” but is priced for meaningful growth. It is the success or failure of emerging market companies to execute on these secular growth opportunities that we believe will drive the asset class to either positive or negative equity returns in 2007. The improving fundamentals certainly support an argument to hold emerging market equities as part of a balanced portfolio but investors should be prepared for short-term volatility. We remain convinced that there are perhaps more reasons than ever before why holding emerging market equities will potentially be beneficial for the long term. 1 MSCI EMF Index and MSCI World Index total return in USD, quoted at month-end with income reinvested. 2 Source: UBS
