CASE FOR INVESTING IN EM STILL INTACT / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

July 24, 2013 9:22 am

 

Case for investing in EM still intact

 

By Russ Koesterich

 

They are still growing faster than developed markets

 

 

The last thing most investors want to hear right now is the long-term case for emerging market equities. Even as stocks have rebounded in recent weeks after a miserable first half, investors are still shunning emerging markets funds.

According to EPFR, a data provider, in the week ending July 10, developed market equity funds took in $15.7bn in new flows, while emerging markets funds experienced more than $2bn of outflows.

 

Equity markets may be rallying again, but as far as US retail investors are concerned it is almost purely a domestic affair. By thinking that way, however, they may be missing an opportunity, especially over the long term.

 

The frustration with emerging markets is understandable. Growth has slowed, the Chinese banking system remains opaque, and the recent unrest in Brazil adds another concern. At the same time, US markets are making daily highs with relatively little volatility. Why take a chance on India or Indonesia when you can generate double-digit returns in safe, transparent US companies?

 

One reason: while emerging market economies have slowed, they are still likely to expand at a much faster rate than developed countries. China is unlikely to ever see double-digit growth again, but 7 per cent or even 6 per cent is considerably better than anything available in the developed world.

 

Of course, the rebuttal to the growth argument is that there is little correlation between growth and investment returns. While this is true, and in the past investors have often overpaid for emerging market growth, the difference now is that emerging markets look more reasonably priced than in some time.

In late 2010, for example, a broad emerging market index was trading at a premium, based on price-to-book, to developed markets. Today, in contrast, emerging markets trade at a discount of approximately 30 per cent to developed markets. Three of the four Bric countries (Brazil, Russia, India, China) are trading at less than 10 times earnings (the exception is India). Emerging markets still face many headwinds, but the risks appear to be priced in.

 

Finally, it is worth reiterating that many of the factors that initially attracted investors to emerging markets are still in place. These countries continue to liberalise their economies, and in certain respects look better than the developed world. Most are models of fiscal rectitude with sovereign debt-to-GDP ratios well below 50 per cent, compared with more than 100 per cent in the US and more than 200 per cent in Japan.

Indeed, far from abandoning emerging markets, many investors should consider extending the definition to include frontier markets as well. Surprisingly, while emerging markets have struggled in 2013, the more exotic flavour of this trade has done quite well. The MSCI Frontier Market Index has gained roughly 15 per cent in dollar terms through to mid-July, on a par with the US and ahead of a broad global benchmark of stocks.

 

Frontier markets have several factors to recommend them. First, they are among the fastest growing countries in a global economy generally starved for growth. Concentrated in the Middle East and Africa, despite continuing geopolitical issues, many of these nations are expected to continue to lead the globe in growth. In addition, the Middle East is also the obvious beneficiary of high oil prices.

 

Beyond the potential for superior growth there is another, somewhat counterintuitive reason to consider frontier markets: they tend to offer diversification benefits. As these countries are generally at an earlier stage of development, there are few global champions in the indices. Companies tend to be domestically or regionally focused, and as such are less tied to and less correlated with the global economy.

This means frontier markets offer many of the diversification benefits that emerging markets provided 15 years ago, but which is less the case today as EM indices are now dominated by larger, global companies that tend to trade in tandem with global equities.

The recommendation to consider frontier markets comes with a few important caveats. While the asset class has been less volatile in recent months than emerging markets, it is still volatile, much more so tan US domestic stocks. In addition, this is a relatively new asset class, which means liquidity is still a work in progress. These are not assets investors should be looking to trade in and out of.

That said, in a world where even emerging markets are slowing, investors should consider broadening their definition of emerging market stocks to include some allocation to frontier markets as well. The US still merits a large allocation in any equity portfolio, but large should not be taken to mean ubiquitous.


Russ Koesterich is global chief investment strategist at BlackRock

 

Copyright The Financial Times Limited 2013