Telling people to invest in emerging-market equities may sound like advising them to jump head first into a swimming pool mostly drained of water. A dumb move, for sure. Still, it would behove investors to wade in while preparing for the day the pool is refilled.
Receding inflation prospects, pro-growth fiscal policies, solid corporate earnings, evolving domestic demand, a still- intact economic growth story, relatively low “free floats” and low valuations all suggest that the emerging-market equity story still has legs.
What’s more, this asset class has grown too big to ignore. In 2007, emerging economies accounted for almost one-third of global income and production, up from 20% in 1993, or about the same as developed Europe and a fifth bigger than the US, according to UBS AG. Brazil, Russia, India and China — the so-called Bric economies — made up one-eighth of global gross domestic product (GDP).
Measured by purchasing power parity, emerging countries equal 47% of global output, according to the World Bank, while the four Bric countries combined account for more than either the US or Europe. The developing world represents more than 60% of global growth, compared with less than half that in 1990, UBS said in a recent report.
Faster growth than developed countries spells superior investment returns. During the 20 years through the end of August, the MSCI Emerging Markets Index had an average annual total return of 13%, measured in dollars. That compares with an 8.1% average annual total return in developed markets, as measured by the MSCI World Index. Comparable numbers for the past 10 years are 18% for emerging-market equities and 5.8% for major stock markets.
The recent results aren’t as pretty. Emerging stock markets tumbled 31% in 2008 through 10 September, led by declines of 61% in China, 42% in Russia and 29% in India. Slowing global growth, high inflation rates, central banks battling the price increases with tighter monetary policies — which damp domestic growth — are behind the market declines. So is the rising cost of food, meaning less spending on other items.
Developing-country stock exchanges are “heavily weighted in commodity-related stocks, with energy and materials accounting for 21% and 9%, respectively, of emerging-market capitalization,” said Montreal-based BCA Research Ltd in a report last month. “When these sectors fare poorly, performance of this asset class as a whole is dragged down.”
War, domestic political tensions and territorial disputes involving Russia, India, Pakistan, Thailand, Malaysia, South Korea, Venezuela and Israel also play their part. Investors pulled $23.7 billion (Rs1.08 trillion) out of emerging-market equity funds in the past 13 weeks, says Brad Durham, managing director at EPFR Global in Cambridge, Massachusetts.
So much for the bad news. Weakening growth and declining energy and food prices should ease inflation pressures and permit emerging-market central banks to loosen policy. That should boost growth, which in any event will continue to surpass that of developed countries in years to come.
As of the end of July, earnings per share (EPS) for the companies in MSCI’s Emerging Market Index were up 23% from a year earlier, according to Merrill Lynch and Co. Inc. EPS growth in industry groups associated with domestic demand — consumer, telecommunications, industrials and financial services — rose 29%, Chinese retail sales growth exceeded that of the nation’s exports for the first time in June.
“Domestic demand is the secular growth story in emerging markets,” says Michael Hartnett, Merrill’s head global emerging-market equity strategist in New York.
Meanwhile, many developing nations continue to be blessed with high levels of savings and current-account surpluses. Several are increasing government spending, especially in areas such as infrastructure. Emerging-market countries also enjoy a liquidity advantage over their developed counterparts in the form of very large foreign-exchange reserves and sovereign wealth funds.
Emerging markets’ biggest allure may be their cheapness. The MSCI Emerging Market Index is selling at 11.12 times trailing earnings, down 41% from 30 November 2007. Developing-country stock markets are also small compared with their respective economies. China’s so-called free float, or those shares that global investors can purchase, is $396 billion, according to MSCI. That equals 15% of the country’s gross domestic product. The comparable figures for Russia and India are 22% and 21%, respectively. By contrast, the US market’s free float equals 87% of America’s GDP, while the UK stock market’s is 96% of Britain’s economy.
Given the risks, investors shouldn’t bet the farm on emerging markets. But they shouldn’t ignore them, either. The best strategy is to ease into these markets slowly over a protracted period, using some form of dollar-cost averaging. Even so, if Russia invades Ukraine or Israel bombs Iran, all bets are off.