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Emerging markets have an adventurous ring to them, calling up images of new frontiers and undiscovered riches. The reality is marginally less glamorous. The 27 26 or so emerging markets represent about a fifth of the world’s gross domestic product but four-fifths of the world’s population. They are small, developing economies on the economic fringes with an the average annual income of less than $10,000 a year.
Most are growing fast – as much as double the growth rates of the UK or US – at more than 5 per cent. But they have porous rules on investor protection and anyone who has invested in them in the past decade has experienced extreme turbulence as they lurched from crisis to crisis. There was the tequila turbulence in 1994 when Mexico devalued its currency, then the Asian crisis of 1997 and 1998. currency crisis in Asia in 1997. A year later, Russia devalued its currency and defaulted on its debt, causing turmoil in emerging markets from Korea to Venezuela. More recently, Argentina’s travails ricocheted around the asset class causing widespread falls. Experience suggests that almost anything – an inflation shock, a hike in US interest rates, a political coup or war – can set off one of these bouts.
The latest scare hotspot is the recent spike in oil prices to record highs. Some developing markets that produce oil – notably Russia, Venezuela and Mexico – are benefiting, but analysts worry that record high prices it will cause global economic growth to slow and inflation to rise and this will spark a downturn in emerging markets.
However, investors are optimists and fund managers claim that things are changing. The factors that caused much of the turmoil of in the past decade are no longer present, they argue, there and the developing economies are in better shape than they were even a year or so ago. Inflation is under control. Companies and governments have learnt from past crises and have much greater respect for good corporate governance and shareholder rights. Balance sheets have been rebuilt and companies and have unwound the positions where they matched US dollar-denominated debt against to domestic assets, which US$ debt mismatch to local domestic assets, that made them so vulnerable to US interest rate rises.
Emerging economies, particularly in Asia, are under-geared with loan-to-asset ratios considerably below normal, says Percival Stanion, head of asset allocation at Barings Asset Management.These The bulls argue that not only are emerging markets are safer than they were but and they are cheap, trading on price multiples of earnings of less than 10 against p/es in the US of about 17 times and in the UK ratings of 13 times.
“The argument is that emerging markets should be at discounts because they are more volatile than developed markets. That’s true of individual markets. But collectively the asset class is much more stable,” says Stanion.
Moreover, analysis of these markets has become more sophisticated as investors differentiate between, for example, the Asian economies that have such a strong technology manufacturing bases and the Latin American countries that produce so much of the world’s raw materials.
Merrill Lynch’s global emerging markets team has identified a distinct correlation between the risky asset classes of emerging market equities and bonds, high yield bonds and small companies.
Barings says equities are risky assets, whether in the US, the UK, Asia or emerging markets, which is why only 40 per cent of the assets in its balanced funds are invested in shares. But the trade off between risk and reward in emerging markets means that a third of that equity portfolio is in emerging markets.
Some bulls even argue that emerging markets will suffer less from contagion than they have in the past, and - are less contagious than they were – a crisis in one country won’t have spread across the asset class. in the same way it has in the past.
For cynics, this is a stretch too far. Emerging markets are often illiquid, they warn, and therefore tend to be highly volatile investments, affected by sharp fluctuations in sentiment and reversals in capital flows. “As always, a sustained shock to global liquidity and/or to risk appetites has the potential to make macro-frailties in some emerging countries more manifest,” says Merrill Lynch.
When the economic outlook is positive and risk tolerance is high, emerging markets attract investors. But when investors from the US or other big, developed economies – many of whom have borrowed dollars for the purpose – become nervous, the first thing they do is head for home.
A rise in US interest rates could cause interest rates to rise around the world, undermine currencies, escalate the burden of dollar-$denominated debt, raise the spectre of inflation and reverse capital flows back to the US. This fear caused emerging markets to dip in March and continue weak throughout through the summer.
As it happened, US growth did not slow and interest rates did not rise as sharply as anticipated, says Allan Conway, head of Schroders emerging markets, and 2005 looks set to provide a much more benign environment for emerging markets than it did earlier in the year.
Nonetheless, emerging economies are still heavily affected by the economic cycle and – as producers of about three quarters of the world’s commodities – demand for raw materials.prices It is always wise, thereforeofre, to keep a weather eye on the economies that drive world growth.
That means the US, currently, or possibly in the future China, which analysts point to out as the world’s most populous economy, may possibly will come to dominate the global economy in time.
“Emerging market equities have behaved very much like a cyclical asset class in the past 10 years, outperforming in periods when global economic leading indicators are accelerating and under performing when leading indicators decelerate,” says Merrill Lynch. Which is why they are often billed as warrants on global growth – that means you can win a lot but also lose a lot.