Allan Conway, head of emerging markets at Schroders, is all fired up. He has just returned from speaking to some of the world’s biggest pension funds at an emerging market conference in the US.
He says the interest in investing in developing economies has been taking off. Up to now, pension fund managers have earned high returns from investing in listed equities in their home markets without having to be adventurous. But in a low inflation environment, more are turning to alternatives, such as high yield bonds, emerging market equity and debt and private equity, to boost returns.
Schroders is looking for a return of between 8 and 10 per cent in 2005 from emerging markets. Developed economies will struggle to turn in more than half that. Schroders’ estimate is perhaps slightly higher than consensus but it is not gung-ho, says Conway. Substantially stronger economic growth from most emerging markets led to total returns of more than 25 per cent in 2004 and 50 per cent in 2003.
In the past six years - since the last great crisis in emerging markets ravaged shareholder returns - the MSCI emerging market index has risen 108 per cent. Developed markets have risen about 13 per cent.
Over that time, the downside risks attached to emerging markets have fallen, says Conway. Emerging markets, in aggregate across the 26 or so countries that make up the index, are now less volatile than the German Dax index, the US’ Nasdaq or the Japanese Nikkei index.
Schroders’ optimism is echoed by Scottish Widows Investment Partnership, the investment arm of Lloyds TSB, which reckons global emerging markets will return 16 per cent compared with 13 per cent in the developed world, while the price/earnings ratio is 10 times against 15 times for most G8 countries. Swip expects returns of about 10 per cent this year.
Lazard Emerging Markets Growth fund, which has been a top performer, is less sanguine. It is concerned that valuations were not as outstandingly cheap as they have been. However, “recent profit taking appears likely to release pressure on the asset class”.
Cynics - most of whom were burnt in the tequila crisis of 1994 when Mexico devalued its currency, then again the Asian crisis in 1997 and by the Russian debt default in 1998 - are quick to point out that emerging markets lurch from disaster to disaster every four or five years, with intervening bouts of euphoria. They say recent market reactions to the poor start of the US reporting season, coupled with evidence of slowing US demand and sluggish retail sales, show how vulnerable markets are to news emanating from the US. Commodity prices - on which so many emerging markets rely - and the emerging market index fell sharply.
However, Joanne Irvine, Aberdeen Asset Management’s head of emerging markets (except Asia) says: “Crisis forces governments to reform and it also forces changes at a company level. In the last few years, [this has brought] significant political stability, structural change and fiscal discipline. Weak currencies have turned current account deficits into current account surpluses. Companies have been forced to restructure balance sheets and improve corporate governance.”
Much of the optimism is being driven by the growing force of China. Developing markets have historically been tied to global economic growth rates, led by US demand. But while US import demand is weakening, China is playing an increasing role in world growth.
The World Trade Organisation says China has overtaken Japan as the world’s third largest exporter, led by surging demand for its electronic goods. China is also sucking in imports from other regions. African and South American exports were up more than 30 per cent in 2004.
So, how to invest? Financial planners advise investors, however bullish, not to put much more than 5 per cent of assets in emerging markets. Many people, swayed by the China story, will focus on Asia emerging market funds. But Standard & Poor’s, which measures fund performance, recently pointed out the wide variation in returns, driven by strong performance from some countries. Returns from South Korea, for example, over the past three months have risen 20 per cent, largely because of the strength of the local currency. This compares with flat performance from Hong Kong, where the currency is pegged to the dollar.
Stock picking and sector choice was also important. For example, Baring’s Hong Kong China fund made the wrong call and backed local small-cap stocks, which were hit by fraud scandals, while being underweight in property companies, which were much stronger. Schroders, too, had “performance issues which we are now addressing,” says Conway.
It is less risky to pick a more diversified global emerging market fund. But bear in mind that some investment houses have historical biases. For example, Aberdeen and Schroders have leant towards Asia. Merrill Lynch Investment Management has traditionally had a strong base in Latin America.
Even within regions, investment houses will weight a country’s prospects differently. For example, Aberdeen says it will maintain its overweight position in Brazil and Mexico because of the “lack of quality companies in the smaller regional markets” in South America. In direct contrast, Credit Suisse First Boston is taking an underweight position in Brazil versus the index. “Asian markets are likely to be much more defensive,” it says. Schroders, too, is downbeat about Mexico, on worries about its sensitivity to US rate rises.
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