After a poor 2011, these economies are bouncing back

By Vikram Barhat | April 1, 2012 | Last updated on April 1, 2012
4 min read

Emerging markets are dishing out healthy returns to investors—and a big slice of humble pie to detractors.

After falling 21% last year, the MSCI Emerging Markets index rebounded strongly this year. The index was up 11% in January, outpacing developed markets by 7.6%. The Dow Jones Industrial Average rose only 3.4% during the same period. At the macro level, emerging economies continue to be the fastest-growing, says ChukWong, vice-president and portfolio manager, Dynamic Funds; co-manager, Dynamic Emerging Markets Class.

“Industrialization and urbanization continue to take place [in these economies],” he says. “They have favourable demographics compared to the developed world.” Inflation, the primary concern in the first half of last year, is peaking in some of these markets. In China, inflation topped out last July, leading to monetary policy easing; that’s currently unthinkable for the industrialized word.

“We are at this inflection point when monetary policies [in emerging markets] are switching from tightening to neutral to easing in the future,” said Wong. “That is constructive for equities.”

In another sign of easing, key central banks in emerging markets have lowered their cash-reserve ratio. The People’s Bank of China cut the reserve ratio for its banks by 50 basis points in December. Paul Mesburis, senior portfolio manager at Excel Funds, points out that at 20.5%, there’s ample room for further easing.

The Reserve Bank of India, that country’s central bank, also reduced its cash-reserve ratio by 50 basis points to 4.75% and signaled future rate reductions.

But history provides the strongest arguments for remaining positive about the future of emerging markets equities. “Historically, equities are known to rally after central banks ease monetary policy,” said Mesburis.

“We expect further easing across emerging markets [as they] grow at about 5.1% in 2012 and 6% in 2013, compared to industrialized countries, which are expected to grow 0.9% and 1.2%, respectively.”

Led by China and India, emerging markets contributed to about 70% of global GDP growth in 2011. That’s expected to increase to 76% in 2012, Mesburis says.

This trend is further supported by growing signs of a U.S. recovery and expectations of a workable solution to the European sovereign-debt crisis, which contributed to emerging-market equities’ underperformance last year. This has helped lower the risk perception of global investors.

BRICs still interesting

BRICs have been the most fashionable markets, says Gustavo Galindo, portfolio manager, emerging markets at Russell Investments. “Among other things, it’s [a group of] countries from four regions and it gives [investors] a sense of diversification.”

But as attractive as the BRIC concept is, advisors should look beyond. Galindo says considering “quasi-developed economies” like Mexico or South Africa is a good idea. Even a smaller country like Indonesia was “a great performer in 2011 because of the macroeconomic development. And because it started from such a low base, the growth was easy to generate.”

Wong, who gives Indonesia and Thailand top billing in the Association of Southeast Asian Nations region, agrees.

“Last year, Indonesia was one of the best-performing economies in the world, with a low volatility,” he said. “[It] will continue to do well in the foreseeable future. Thailand looks attractive because it had a major flood [last year] that actually caused valuations to come down.”

Moody’s and Fitch recently promoted Indonesia to investment grade. About 60% of emerging markets now have that status.

Detractors often argue macroeconomic indicators don’t always translate to upticks in equity markets, pointing to 2011 as proof.

But experts like Mesburis are counting on untrammelled emerging markets enthusiasm this year. “Emerging markets as a whole are up 12% on a year-to-date basis, versus 3.5% for the TSX,” he says.

“The valuations are quite attractive. The forward P/E multiples are about 10 times below their longterm averages—and we expect continued growth coming out of the EM space.”

Yet the average investor tends to stick with North American companies they know and trust. Many of these companies are global and have benefited from increasing their exposure to emerging markets. Investing in these companies offers Canadians another way to participate in the compounding growth of these markets.

There’s a problem with that approach, though. Wong argues local companies in emerging markets generally outperform global companies and their local subsidiaries. “If that’s the case, other things being equal, you want to invest directly,” he says, calling that a pure play.

Galindo agrees, saying playing emerging markets through developed market companies offers diluted returns. Besides, greater familiarity with North American companies often comes at the cost of higher valuations.

“The average company in developed markets is considerably more expensive, [particularly] if it has exposure to that growth in emerging markets.”

Emerging markets tend to be volatile and are affected in varying degrees by global macro events. One way to counter volatility is to invest in emerging market debt via bonds, bond funds and ETFs.

Emerging-market fixed-income has been the best-performing asset class for over a decade, thanks to a combination of high yields and improving credit quality.

Standard & Poor’s currently rates bonds from China AA-, India BBB- and Brazil BBB. Everything above BBB- is considered investment-grade. By contrast, some developed countries like the U.S., Italy, Spain and Belgium, have seen their triple-A and double-A ratings downgraded. This makes emerging markets look even better.

“Some of the emerging-market economies have come of age [and their] debt looks attractive,” says Wong. “We are already seeing a number of economies that have been upgraded to investment grade.”

Investors also need to consider currencies, says Galindo. “They can move dramatically in emerging markets.”

To remove currency risk, investors can either choose traditional emerging-market bonds, denominated in U.S. dollars, or invest in emerging-market funds that invest half in local currencies and half in stronger currencies like the U.S. dollar.

Vikram Barhat