Leaping tigers, hidden dragons

While Canadian investors and money managers recognize the growth potential of EMs, recent studies show few are taking full advantage of the opportunity.

The EM story reads better in numbers. They represent over 80% of the world’s population; over 70% of its land mass; 70% of its global foreign exchange reserves and nearly 40% of the global GDP; but only 13% of the global equity market cap.

“That discrepancy is one of the significant growth drivers of future equity returns,” says Paul Mesburis, senior portfolio manager at Excel Funds. “We expect in 20 years, emerging markets will represent 55% of global equity markets, about a sixfold increase from present in terms of dollars.”

Mesburis’s forecast is more or less consistent with numbers from on-the-ground experts in EMs.

“It’s inevitable that emerging markets, which constitute less than 30% of global market capitalization, will have an increased share—close to 45% by 2013- 2014,” says Pallav Sinha, chief executive and president, Fullerton Securities and Wealth Advisors, a wealth management firm in New Delhi, India. “This would be the inflection point at which EMs will overtake the developed world in global GDP share, with 51% of GDP coming from EMs.”

Detractors are quick to point out recent slowdowns in these countries. Sinha calls that a myopic observation. “While from a short-term perspective the investment outlook in EMs does not look promising, for a long-term value investor, these markets will definitely provide good returns,” he says.

And, he predicts a world where these economies persistently outpace their developed counterparts. “The pace of growth in the emerging markets will slow,” says Sinha. “[But] the IMF forecasts indicate EMs will grow at a rate 4% higher than developed markets in 2012; the trend is likely to continue for many years.”

Inflation and tightening

Rising inflation, and the monetary policy tightening it spurs, are by far the two biggest bugbears. In India, inflation rose to 9.78% in August, its highest level in 13 months—spurring the Reserve Bank of India to increase interest rates 12 times in the last 18 months. Governments in EMs have been aggressively tackling the issue of inflation. Conversely, industrialized economies are taking it easy.

Sinha believes there could be some softening of commodity prices by December or early next year, which would have a salutary effect on inflation. “The risk is not as much about the increasing inflation rate, but about persistent and structural inflation. Investors do need to be wary of this risk as it could imply lower growth than is being currently projected.”

Mesburis expects inflation in these markets to peak soon, whereas monetary tightening in developed markets is only starting.

This tightening has raised fears about equity valuations, leading equities in these markets to underperform relative to developed markets. But Mesburis asserts the peaking of inflation means emerging market equities will perform better.

Deepening fears over global recession and the Eurozone debt crisis have also hammered emerging market stocks, which have fallen 22% since August 1. On the flip side, say emerging market gurus, this has created an opportunity for Canadian investors to make or expand portfolio allocations.

Growth factors

Over the long term, global macroeconomic headwinds will be outlived by the underlying factors favouring EMs—lower sovereign risk, faster economic and earnings growth, and structural improvements.

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

It’s the dawn of a new era where rising disposable incomes, high savings and low credit penetration put EMs at the beginning of a new consumer credit cycle.

“What’s good [about EMs] 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.

EMs, says Sinha, have a high savings rate and low level of debt (around 40% of GDP). “Their share of global consumption is also up from 22% in 1990 to 35% in 2010; all of these are positive indicators,” he says.

There are two ways Canadian investors can play the consumption story in EMs, says Stephen Lingard, co-lead manager, Quotential Program, and director of research with Franklin Templeton Multi-Asset Strategies.

“You can play that through direct investments in consumeroriented companies within EMs [or] through multinationals [in] developed markets that increasingly gain [from] the growth of consumerism in emerging markets,” says Lingard.

Valuation anxiety

The extraordinary returns from EMs equity exposure have driven valuations higher. This is a growing concern, particularly among those still waiting to take position in those markets.

Sinha dispels these fears with key data around valuation. “The emerging markets index, MSCI GEMS, has corrected steeply by 9.2% in August and a further 7.8% this month. MSCI GEMS now trades at 8.4 times for one year forward earnings, a 26% discount to its historical average of 11.4 times.”

This makes valuations of EMs quite attractive for an investor with a medium- to long-term horizon.

Mesburis also recommends investors view the current market turmoil as an opportunity to take advantage of attractive valuations.

Historically, EMs have traded at a discount to developed markets. In fact, the discount was as much as 55% coming out of the 2001-2002 post-tech-bubble recession. Not anymore. “The market is questioning whether that discount continues to apply,” says Lingard. “EMs are typically less stable governments and deserve some kind of discount versus stable, well-functioning democracies.”

That perception is being reshaped by the huge debt and deficits and political quicksand of the developed word.

“EMs are increasingly better governed and [have] more balanced economies; there are fewer coups and corruption is being tackled.This is all positive in the long term for valuations,” says Lingard.

“Previous to the crisis of 2007- 08, EMs were actually trading at a peak premium of 10% to developed markets. Bottom line, in terms of growth, EMs are in better shape than advanced economies.They’re now trading at a 20% discount, which is less than historically, but you could even argue for higher valuation going forward based on stronger fundamentals.”

risks and hedging

Despite their get-rich-quick appeal, investors should enter these markets with caution.

“Economic growth of [EMs] is not always translating into earnings for shareholders because of corruption and government inefficiencies,” says Lingard. “As governments and securities regulators tackle corruption problems aggressively, [there’s an argument] for a premium for EMs.”

Additionally, emerging market governments have been pursuing mercantilist policies to stop exchange rates from appreciating, creating currency undervaluation. So when they appreciate, they can trigger a double whammy of windfall for Canadian investors: capital growth and currency returns.

In the near term, though, there could be a reversal of fortunes. “In the short run, EMs are far more vulnerable to swings, which can be compounded by currency risk,” says Sinha.

In September alone, the Indian rupee depreciated 3.5% versus the Canadian dollar; over a one-month and one-year period depreciation is 5% and 7.8%, respectively.

“Evidently investors in EMs need to have patience and ride out rough patches and economic downturns, [but over the] long term emerging-market investments definitely justify the risks,” says Sinha.

All things considered, it seems likely EMs will continue to outpace developed markets over the long term.

“Current troubles notwithstanding, emerging market countries—including China, India, Russia and Brazil—continue to be the drivers of growth in the global economy,” says Mesburis. “The United States and Europe are now in the passenger seat along for the ride.”