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July 19, 2013 7:16 pm
The case for investing in emerging markets seems beguilingly simple. They are growing and urbanising fast. They have young populations who aspire to consume as we in the west do. They generally have sound public finances, with no bloated welfare states or dependency cultures. So companies that are active in those markets should be able to increase profits and dividends rapidly, and their share prices should reflect that.
But all too often, it doesn’t work that way. Emerging markets suffered a savage sell-off when Federal Reserve chairman Ben Bernanke said in late May that the central bank’s programme of bond purchases might be reduced later in the year, provided the US economy continues to improve. The MSCI Emerging Markets index, which measures the performance of the more advanced developing-economy stock markets, is down almost 10 per cent year to date. By contrast, the FTSE All-Share index is up 12.6 per cent, despite the UK’s anaemic growth.
Explaining the most recent sell-off is fairly easy. “When the Fed talked about withdrawing liquidity, Americans withdrew their money from other markets,” says Jane Sydenham, investment director at Rathbones, the wealth manager. According to EPFR Global, a data provider, emerging market equity funds worldwide saw outflows of $3.4bn in the week ending June 19, while debt funds shed $2.6bn.
Such capital flight hits emerging markets particularly hard because their stock markets may be small both in absolute terms and in proportion to their economies. The entire Philippine stock market is only slightly bigger than Royal Dutch Shell. Russia’s market accounts for 43 per cent of its economic output, according to the World Bank, whereas the UK’s market is worth 1.25 times the UK economy.
But American stimulus isn’t the only thing that is tapering. Strategists at BlackRock argue that if anything, changes in monetary policy in China has had even more impact. The Chinese government injected vast amounts of liquidity into the system from March 2009 onwards, much of which went into fixed-asset investment such as infrastructure and real estate. “The stimulus from China bailed out all the emerging markets,” says Sergio Trigo-Paz, head of emerging markets fixed income at BlackRock. “The heavy investment in fixed assets there shielded them from the subprime crisis. It’s been a great tailwind.”
Nowhere was that more true than for big commodity producers such as Brazil. As the dollars poured in, structural reform seemed like something that could be put off for another day. “Although warnings of quantitative easing tapering have seen what looks like a mass rush for the exit, there is some evidence that the outflows are hitting those countries with the worst fundamentals hardest,” says Keith Wade, chief economist at fund manager Schroders. “Brazil has myriad other issues which should worry investors.”
And China’s strategy has changed, with the latest five-year plan switching away from exports and heavy investment in fixed assets and towards a more balanced, consumption-led economy. The Chinese leadership seems happy to accept lower headline rates of economic growth as a trade-off; GDP growth has dropped from a peak rate of 13 per cent in 2007 to about 7.5 per cent now.
But what about the longer term? Does the case for emerging markets stack up – and is there any link between fast economic growth and market returns? There is, says Paul Marsh, emeritus professor of finance at London Business School – but it is very difficult to exploit. “Strong economic growth is generally good for markets, but markets are good at impounding that into prices . . . investors shouldn’t look at past economic growth and assume that it isn’t already reflected in prices,” he says.
Investor enthusiasm for emerging markets comes and goes, resulting in periods of outperformance but also periods of poor returns. “Since 2000 it has been true that emerging markets have given better performance,” says Mr Marsh, who along with LBS colleagues Elroy Dimson and Mike Staunton, has assembled a database of stock market performance going back to the start of the 20th century. “But over the longer term – since about 1975 – the difference [between emerging and developed markets] has not been that great.”
Our chart shows this from a UK investor’s point of view. It looks at total returns from emerging markets in sterling terms, and compares them to UK market returns and UK inflation. Over the past 20 years, emerging markets have delivered better returns, but it has been a bumpy ride. There have been long periods of underperformance – emerging markets took almost 10 years to recover from the 1997 Asian crisis and Russia’s 1998 default, for instance – and volatility has been greater.
According to Mr Marsh, emerging markets are becoming less volatile as they grow. But the flip side of that is that they are becoming more correlated with developed markets.
There’s also the issue of how much investors should expect to pay for developing market exposure. “Emerging markets are high growth, for which you might expect to pay a premium,” says Mr Marsh. “But there’s a contradiction in that they are also high-risk, for which you might expect a discount.”
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Which view holds sway depends on investors’ collective view of the world; until recently, investors were prepared to pay a premium since emerging markets were regarded as insulated from the debt problems of the west. But a moderation in the pace of economic growth – the IMF recently downgraded its forecasts for many key emerging economies – plus the political unrest in Egypt, Turkey and Brazil, has reminded investors of the many risks, and they are now demanding a discount. “I can’t help feeling that the current revulsion is as irrational as the euphoria that went before it,” says Mr Marsh.
Ms Sydenham agrees that having no exposure at all would be unwise given the periods of turbocharged performance that emerging markets sometimes deliver. “If you took a balanced portfolio, we would only have about 4-5 per cent emerging markets exposure, out of 30 per cent overseas equity market exposure in total.”
Is now the moment to be adding to that exposure? “In valuation terms, emerging markets look cheap. Ten times earnings is in the bottom quartile of the historic range,” thinks Dhiren Shah, a member of the emerging markets team at BlackRock. But strategists at the fund management group are not convinced the sell-off is over, despite a partial recovery. “We are about two thirds of the way through the correction. I expect another two or three months of volatility, especially over the summer when liquidity is thinner. Only in the last third does it get compelling, and when will we see the other third is the biggest question,” says Mr Trigo-Paz.
There’s also the issue of which markets to buy, now that the rising tide of liquidity is not going to float all the boats. “It’s the end of the beta story and the start of the alpha one. It’s Brazil versus Mexico and Turkey versus Russia.”
Many commentators now express a preference for members of the Association of South East Asian Nations (Asean) over the traditional bloc of Brazil, Russia, India and China. Mexico is another country attracting interest. “After 2008, Mexico was among the weaker emerging markets because it did not benefit so much from China’s stimulus. But that lack of tailwind spurred structural reform,” says Mr Trigo-Paz.
And structural reform, according to many experts, is what emerging economies need more of now that the easy money from using cheap currencies to stimulate exports has been made. “We need to see economic growth bottom out and the earnings picture improve,” concludes BlackRock’s Dhiren Shah.
Ways into the emerging market story
For most UK-based investors, buying shares in Jakarta or Mexico City is unrealistic, so there are two main ways to add exposure to emerging markets: via funds or investment trusts, or by buying shares in UK, US or European companies with high levels of emerging market exposure.
Paul Marsh, emeritus professor of finance at London Business School, says he knows of no evidence to suggest that active management delivers returns in emerging markets that are any better than in developed ones, and argues that passive vehicles are as good a vehicle as any for accessing emerging markets.
BlackRock, Legal & General, HSBC and Vanguard all offer index-tracking funds structured as open-ended vehicles, though at 0.5 per cent and more, their expense ratios tend to be higher than developed-market funds.
There is a great deal more choice of markets and sectors with exchange traded funds (ETFs) – iShares alone has 18 single-country funds. However, many ETFs are denominated in US dollars, which introduces some exchange rate risk, and some are quite small.
Bear in mind that any product tracking the MSCI Emerging Markets index will have significant exposure to Chinese shares trading in Hong Kong, as these make up about a fifth of the index. The index also has heavy weightings to commodity-dominated markets such as Russia, Brazil and South Africa.
Jane Sydenham thinks the peculiarities of emerging markets justify the expense of active management. Most fund pickers advocate generic or regional funds to diversify risk, rather than single-country funds.
HFM Columbus’s investment director Rob Pemberton says that First State and Aberdeen are “head and shoulders above the rest” in this space – but most of their funds have taken steps to limit the flow of new money. Aberdeen’s flagship UK-domiciled emerging market fund imposes a 2 per cent charge on new investment, while First State’s Global Emerging Market Leaders will impose a 4 per cent initial charge from September.
Closed-ended funds don’t suffer from such liquidity issues, and there are 10 of them in the Association of Investment Companies’ global emerging markets sector. The Templeton Emerging Markets Investment Trust was set up before the MSCI EM index was even created and is still going strong today. China accounts for over a quarter of the holdings, but there is significant exposure to Thailand, Indonesia and Turkey as well. JPMorgan’s Global Emerging Markets Income Trust offers a focus on shares with strong dividend prospects, while the Utilico Emerging Markets trust concentrates on infrastructure.
For those buying individual shares, the question is whether to tap into the urbanisation story – typically via mining shares such as Rio Tinto, BHP Billiton and GlencoreXstrata – or the consumer one. Companies as diverse as spirits group Diageo, brewer SABMiller and luxury goods group Burberry are all increasing their exposure to rapidly-expanding middle classes in Asia, Africa and Latin America.
Most of these companies’ shares look fully valued compared to the UK market average. But Simon Edelsten, manager of Artemis Global Select fund, points out that they look much cheaper relative to peers in local markets. He cites Unilever – a classic emerging market stock – as an example. Its shares trade at 17 times historic earnings, but those of its Jakarta-traded Indonesian subsidiary are rated at 36 times past earnings, while Mumbai-quoted Hindustan Unilever trades on 30 times. “Emerging markets now comprise well over half the parent’s sales and dominate overall growth,” he says.
Emerging – the new markets
Even index providers cannot agree on precisely what constitutes an emerging market. MSCI, the US company that introduced the benchmark MSCI Emerging Market index in 1988, defines an emerging market in terms of the number of quoted companies of a certain size and “free float” (the proportion of shares available for ordinary investors to buy), plus a market’s openness to foreign ownership and capital.
The MSCI index still includes South Korea, a relatively developed market, whereas FTSE’s emerging markets index does not.
The acronym “Brics” was coined in 2001 by Jim O’Neill, then chief economist at Goldman Sachs Asset Management, to describe the four titans of Brazil, Russia, India and China. It’s been followed by HSBC’s “Civets” – Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa – and the “Next 11” – Bangladesh, Egypt, Indonesia, Iran, Korea, Mexico, Nigeria, Pakistan, the Philippines, Turkey and Vietnam.
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