Emerging outpacing developed markets

For one thing, the extraordinary returns from emerging markets equity exposure have created irresistible temptation. It has also created some doubts, but the rewarding opportunities, experts argue, far outweigh the potential risks.

Fears about rising valuations and arguably reducing diversification benefits of emerging markets have done little to curb investor enthusiasm. Nor have these fears changed financial experts’ outlook for these markets. If it was sunny the past year, it’s even brighter now.

“What’s good [about emerging markets] is incredibly high growth rates [and] per capita income moving up at a rapid pace, because the economic growth rate is very high, and population growth is very low,” says Mark Mobius, executive chairman of Templeton Emerging Markets Group.

As foreign reserves reach sky-high levels, and their safety profile shines up, perceptions about emerging markets continue to improve. “People are beginning to realize they’re not as risky as they seem,” says Mobius.

On the flip side, this has also meant rapidly climbing valuations, which is a growing concern, particularly among those who are eager to enter emerging markets but feel it may be too late.

Ajay Argal, head of offshore equities at Birla Sun Life in India, who also manages Excel India Fund, Canada’s longest-running India fund, says it’s about how you measure valuations. “The valuations must be looked at in context of growth of the country (GDP) and in the context of return ratios,” he said. “A more relevant parameter to look at is the PEG multiple, which is the price to earnings growth multiple.”

The PEG ratio uses the P/E ratio of a country’s main equity market index as a factor of estimated annual GDP growth of a country. As with stocks, the lower the country’s PEG, the more attractive the country’s investment potential. Argal employs this reasoning to assert valuations in emerging markets — particularly in India, given its growth potential — are quite reasonable.

Mobius couldn’t agree more. “There’s still quite a lot of value, because the earnings growth is keeping up at a rapid pace, so we still are finding opportunities.”

“Valuation metrics suggest a positive outlook for emerging markets in 2011, supported by benign global liquidity conditions and accelerating global growth,” says Phil Langham, senior portfolio manager and head of the emerging markets team at RBC Global Asset Management.

The rebalancing of global recovery and domestic consumption continue to be strong themes in emerging markets. “Growth in the emerging markets world remains very healthy, driven by a lack of government and consumer debt,” adds Langham.

The underlying factors favouring emerging markets — lower sovereign risk, faster economic and earnings growth, and structural improvements — still exist. There are, however, near-term risks to consider, says Kevin Eng, portfolio analyst at Russell Investments in Toronto. “These are mostly centred on the potential for a deeper-than-expected slowdown in China and the potential for volatility around the themes of rising inflation, currency appreciation and capital controls, which could temper the outlook.”

One of the attractions of emerging markets is the breadth of long-term investment opportunities across a broad cross-section of markets. “We currently overweight the benchmark index in Turkey, South Africa and Russia,” says Eng. Experts are also inclined to overweight the likes of Korea, Taiwan, and China in Asia.

Away from markets clustered around Asia, some are excavating Russia, Singapore, South Africa, Brazil and Chile for rich returns.

“[Investing in] Russia is a good way of getting exposure to hard commodities,” says Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management. “The Latin markets are interesting because of their exposure to soft commodities. From a price point of view, prices [of soft commodities] remain supportive in this environment.”

Besides attractive valuations and sustainable growth, the case for equities in emerging markets finds further support from rising incomes, easier access to finance, pro-growth policies and strong population growth.

“With rising disposable incomes, high savings and low credit penetration, emerging markets are at the beginning of a new consumer credit cycle,” says Eng.

The fundamentals of sector selection, critical to stock picking, remain unchanged. “We find our big areas are commodities,” says Mobius. “Oil companies, mining companies: these are really where the earnings are going. Anything related to consumer — consumer banking, retail — is doing quite well,” he adds.

The year 2009 was a great year for equities in emerging markets. Some of these markets were up over 100%. Surely, investors can’t expect that year after year. Yet Mobius assures there is a fair chance 2011 won’t bend the trend. “It just depends on how the markets move, but generally speaking, returns for emerging markets are double that of developed countries,” he says.

If there is still reservation, Langham quickly dispels it. “Historically, emerging markets have consistently outperformed developed markets due to their faster growth, and this superior growth looks set to be maintained,” he says.

Eng’s cautionary tone, in comparison, creates a curious contrast. Performance expectations, he says, should be more moderate than the last five years. “Returns will likely be more sensitive to any bad news, as we are no longer in such an accelerating period of growth and upward revisions in earnings that has been a strong tailwind to global markets.”

Any investment abroad comes with attendant concerns about currency fluctuations, emerging economies being no exception. The good news, however, is the majority of emerging market currencies have appreciated against the U.S. dollar, and by extension, the loonie.

“Part of the reason to be exposed to emerging market assets is expected currency appreciation,” says Poole. “So in that respect, it’s playing out the way it should. That part of your return, measured in your own currency, simply represents currency appreciation of the emerging market effects.”

In addition, many emerging market governments have been pursuing mercantilist policies to stop exchange rates from appreciating, resulting in generally undervalued currencies. As far as Canadian investors are concerned, appreciating currencies in those markets can trigger a double whammy of windfall: capital growth and currency returns.

No one knows that better than Bhim D. Asdhir, president and CEO of Toronto-based Excel Funds. “From our perspective, why pay money to hedge when you’re actually going to make money in the long term?” he says. Asdhir has certainly put his money where his mouth is. About 80% of his own portfolio is allocated to emerging markets, a large part of which is invested in India. Keeping it all unhedged, he has enjoyed both earnings growth and the benefit of currency appreciation.

Eng, yet again, sticks the needle of fact into the bubble of popular belief. “Emerging market currencies as a whole have, in fact, been depreciating rather than appreciating versus the Canadian dollar,” he says. “Last year, the MSCI Emerging Markets Index returned 14.40% in local currency terms, while in CAD returned 12.98%.”

Some detractors of emerging economies — both investors and financial professionals — go so far as to say the diversification benefits of emerging markets equity have actually diminished, particularly in the post-crisis period. Enhanced correlation is said to be the main culprit.

“I think there are still diversification benefits to be had from investing in these economies, but that said, quite often we’ve seen markets trade in a highly correlative way,” says Poole, adding that this correlation exists not just between developed and emerging markets, but within the developed world between different asset classes as well.

The higher the correlations, the lower the diversification potential as a result, he says.

Langham agrees there has been a close link between the Canadian market and emerging market returns over the last few years, but asserts this link will diminish as emerging markets move to being less driven by commodities and more by domestic demand.

The argument for diversification benefit still is alive and well. Mobius finds it in frontier markets. “We have full frontier funds that are investing in Nigeria, Bangladesh, Vietnam, Kazakhstan; these are all very different countries, and the correlation between those countries and the U.S. or Europe is very different, and they’re different from each other as well.”

Eng agrees that investing in emerging markets means far more than just throwing money into the BRICs (Brazil, Russia, India and China). “There are a number of markets that are lesser-known, such as Turkey, Peru, Thailand and Indonesia, which have performed strongly, house some of the strongest growth opportunities and are often less correlated with the broader market.”

Frontier markets are a potential source of diversification because they are small, relatively isolated and exhibit low correlations from country to country. These characteristics reduce overall portfolio volatility, says Langham.

The broad, positive consensus about the medium-term prospects for emerging markets appears to hold true for 2011. But there are some near-term risks that should caution investors, mostly around a slowdown in China and the potential for volatility around the themes of rising inflation, currency appreciation and capital controls.

“Emerging markets individually can be volatile and it is recommended that investors get exposure through a broadly diversified fund in order to reduce country-specific risk,” warns Langham.

One solid risk to watch out for is liquidity. Poole asserts that emerging markets are less liquid than developed markets, which makes them more vulnerable to shocks. Fast and furious capital inflows pose another risk.

“Too much money trying to get invested in the markets can create asset bubbles,” says Poole. “And that’s kind of where we are at the moment, [so] we have to be careful in the future [and] to be aware of that risk.”

The risk profile of emerging markets, no doubt, has not changed substantially since last year, but neither has the positive outlook of most market observers for these economies. All things considered, the fact that emerging market equities have performed well relative to global equities remains virtually incontrovertible.