JANUARY 2010

Investing in emerging market equities developed substantially over the past two decades and most investment portfolios could benefit from an allocation to emerging market equities.  Twenty years ago there was limited investment access to these markets, whereas today these markets offer hope for leading a long-term economic recovery.  The emerging markets, as defined by the widely followed MSCI Emerging Markets Index, consist of 22 countries in Asia, Latin America, and EMEA (Europe, Middle East, and Africa).  Traditionally known for volatile and risky investments subject to substantial political and inflation risks, the emerging markets have generated some characteristics that leave developed markets green with envy.  Emerging markets benefit from cheap labor, a developing middle class, a position of creditor to the world, and expanding infrastructure.  We will look at drivers of economic growth, risks to emerging market investment, and current valuations to support an investor’s long-term allocation in emerging market equities.

 

The hope of economic recovery brought investors flocking to emerging markets with the resumption of risk-taking in 2009.  At the peak of panic in late 2008, emerging markets declined precipitously as investors sought safety, but with hopes of these markets being insulated from the real estate bubble and financial crisis, performance doubled from the March 2009 lows.  As a result, the precipitous fall of 2008 that led to historically low valuations was followed by the stellar rebound of 2009.  One can easily see in the following chart, the strong equity returns enjoyed by emerging market investors.  After returns of almost 80% last year, much attention is given to emerging markets and many investors are wisely cautious of the hype, but still see the ability of emerging markets to persist with long-term economic growth.  

  

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Population

 

Emerging countries account for approximately 57% of the total world population, with emerging Asia as the most populous region in the world.  The developed countries comprise only 13% of the world population, and these percentages are expected to persist into the middle of the next decade.¹  The long-term investment opportunity in emerging markets, however, starts not with the size of the population, but with the demographics of a population this size.  

 

 

While the U.S. worries about the baby boomers approaching retirement, emerging markets benefit from an expansion of population at peak working age.  China, South Korea, and Taiwan, three of the largest emerging markets by market capitalization, have 73% of their populations between the ages of 15-64, over 12% higher than the percentage this age group comprises in the populations of the United States, Japan, and United Kingdom.²  India benefits from a surge of individuals younger than 40 years-old in a country of 1 billion people, as seen in the following charts of the Chinese and Indian populations by age. 

 

  

 

By 2050, the Chinese population should be more evenly distributed and India will look like China does today, with a large number of peak working age adults.  This serves as a reminder that not all emerging markets are identical.  For example, Russia is expected to have a population decline by 2050 with a significant portion of the population in the older age brackets.  When measured against some developed markets, Russia is still in a relatively stronger position.  For example, Japan is faced with a current age distribution comparable to the forecast for Russia in 2050.

 

 

Consumption

 

The increase in working age adults is expected to drive growth in the level of consumption from the emerging markets with companies across the globe hiring low cost labor in emerging markets.  As these economies benefit from a large percentage of working age adults, the middle class should develop both improved wealth resulting in increased demand for modern conveniences.  The following chart highlights the global share of consumption expected in both the industrialized (developed) and emerging nations.

  

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Education

 

The ability of emerging market workers to compete in the global environment will be essential to building increased wealth to support the desire for consumption.  Traditionally, many of these countries were impoverished with poor education levels.  Much like the United States was able to reduce child labor in favor of education after the industrial revolution; emerging markets have made substantial strides in improving human capital with the education of their populations as seen in the following chart of literacy rates.  Additionally, with large populations in China and India, the sheer number of highly educated workers will help these growing economies. 

 

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Purchasing Power

 

Furthering the power of growth for these consumers is their low levels of consumer debt and appetite for an improved lifestyle.  As the market for consumer credit develops, the ease of obtaining consumer goods improves.  For example, in the mid-1990s when consumer financing became available for car buyers in India, car sales more than doubled in 3 years.  When interest rates on auto loans dropped below 20% at the turn of the century, sales jumped immediately, and by 2004 were 4 times the amount sold 10 years prior.³ 

 

A similar situation exists in China, one can see in the following chart that as the Chinese consumer’s income increases to within the range of $2,000 to $12,000 annually, many consumer goods become affordable and ownership of modern conveniences increases, while bicycle ownership declines in favor of the automobile. 

 

 

 

In 2009, one of the more notable illustrations of the emerging market consumer’s development hit headlines when China surpassed the United States in car sales with an increase of 46% in total vehicle sales.  The improved Chinese car sales were due in part to 2009 tax incentives aimed at small cars buyers, which may indicate current sales levels will not persist in the short-term with the recent reduction of these incentives.⁴  More importantly the vast majority of these sales were to first time car buyers.  The Chinese buyer contrasts to U.S. car buyers, who are primarily replacement buyers in an automobile saturated market.  Auto ownership penetration in China increased from an estimated 11 cars per thousand individuals⁵ in 2006 to 40 cars per thousand in 2009,⁶ exemplifying the opportunity presented by the emerging markets consumer’s demand.  The U.S. has an estimated 765 cars per thousand individuals.⁶  The strong response to the tax incentives that spurred entry-level sales and low ownership levels suggest that China is capable of taking and maintaining the auto sales lead in the intermediate to long-term. 

 

 

Impact to GDP

 

With the large populations in these nations, a small level of growth in consumption can have a dramatically positive impact on nominal GDP (gross domestic product).  Currently, emerging market countries comprise less than 30% of the world GDP.  Over the next few years, this share is expected to increase, as GDP growth in emerging markets is expected to outpace that of developed markets.⁷ 

 

The trend of higher GDP growth in emerging markets re-emerged following the Asian financial crisis and the technology bubble that slowed growth, as illustrated in the following chart.  Much of the growth in the mid-2000s was driven by the BRIC countries, which includes Brazil, Russia, India, and China.  These four countries accounted for more than 50% of the growth in emerging markets during this period, and as much as 75% of emerging markets GDP growth in 2008.⁸ 

 

 

GDP growth in emerging markets is expected to continue outpacing developed markets following the 2008 financial crisis.  This is based on the potential for lower output among developed countries, the trend toward globalization of business, technological innovation, and stronger economic positions of emerging countries’ governments.  Meanwhile, elevated unemployment rates and constrained credit availability, amid a healing banking industry, are expected to present headwinds to GDP growth in developed markets.

 

While emerging markets are not isolated from these affects, the impact is expected to be muted.  In a period of slower growth and lower consumer spending in developed markets, businesses will likely continue to search for ways to improve efficiency, which could include moving jobs to lower-wage markets.  Emerging markets would likely stand to benefit, as compensation for the workforce in most emerging countries is below developed markets.  Additionally, emerging countries, most notably in Asia, continue to produce innovative technology that is competitive globally. 

 

 

The economic strength of emerging countries relative to the developed world could also have a significant impact on future growth.  With the Asian financial crisis in the 1990s, many emerging countries improved their financial institutions, reduced debts, began managing government surpluses, and reduced inflation from high double digit levels (in some cases higher).

  

 

This continues to be the case, with few emerging markets running large deficits, unlike the developed world.  In response to the financial crisis, many developed countries needed large government stimulus efforts to prevent grim depression scenarios.  As a result, the most developed countries public debt levels grew tremendously and are forecasted to reach levels greater than 100% of GDP by 2014.⁹  Some emerging markets, most notably China, are now lenders to the developed world.

  

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Commodity Rich Nations

 

The stimulus plans of many developed nations have stoked fears of increased inflation.  Prices of commodities are also expected to rise with infrastructure spending in emerging countries.  This spending could keep demand for commodities at elevated levels, which could then have a positive impact on emerging markets.  The energy and materials sectors account for more than 50% of the equity market in the largest emerging countries, such as Brazil and Russia, and these sectors are positively correlated to commodity price movements.¹⁰

  

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Risks

 

While the long-term investment opportunities in emerging markets appear attractive, they are not without risks.  The potential for political instability, individual country issues, increasing correlation of emerging markets to developed markets, and currency fluctuations are among the most notable risks of investing in emerging markets.

 

 

Political

 

The governments of many emerging markets are not as well established as those in developed countries.  An investor must consider the amount of public participation in the governing process and the stability of government successions.  For example, India has many political parties, China remains under totalitarian rule with national and local government officials wielding power, and Russia has suffered recent instability since the fall of the Soviet Union. 

 

Local governments can alter taxes and/or restrict an investor’s ability to remove capital from the country.  In 2009, Brazil announced such a tax on foreign investors.  A country must be able to ensure property rights of individuals and corporations as well as provide a fair means of settling disputes.  For this reason, some emerging market managers obtain their Chinese holdings in Hong Kong, known as H-shares, to obtain the assurance of Hong Kong listing requirements. 

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Correlations

 

The risk of increasing correlations through time due to further economic integration with developed markets reduces the benefits of international diversification.  While there are many benefits associated with globalization of markets, higher correlations among equity investments may result.  U.S. and European companies also understand the growth potential of the emerging market consumer.  Sales growth of Coca Cola, Crest toothpaste, and other consumer products is focused on these markets.  Thus, an investor’s large cap U.S. equity holdings are not immune from emerging market performance.

 

 

Currency

 

Lastly, ever-present currency fluctuation risk can significantly affect international investment returns for U.S. investors.  A strengthening dollar, relative to the local emerging market currency, reduces returns when translated back into U.S. dollars.  In the late 1990s many emerging market governments pegged their currencies or managed exchanged rates within a tightly controlled range.  Most emerging market countries, however, have begun allowing their currency to float freely in recent years.  China and Morocco still peg their currency to a major global currency, China to the U.S. dollar and Morocco to a basket of currencies.  In some extreme cases, governments in all markets have deliberately devalued their currency, such as Switzerland in 2009 and Venezuela this year.  Investors should be aware that currency fluctuations can affect emerging market returns, and hedging the risk may be costly.

 

 

The Risk of Hype and Hyperbole

 

While there is some division between the emerging regions of Asia, Latin America, and EMEA, the BRIC countries of Brazil, Russia, India, and China have a significant impact on the performance of emerging markets.  Just as the United States has a significant impact on the global equity markets, these markets have increased trade between one another and thus have a strong impact on the performance of each market.  Brazil, for example, is a substantial supplier of commodities to its largest buyer, China.

 

China comprises approximately 18% of the MSCI Emerging Markets Index and presents some unique risks as a result of recent economic stimulus undertaken in 2009 and the Chinese government structure.  China’s strong reserves allowed for sizeable financial stimulus and infrastructure spending of nearly $600 billion.  The government’s structure enabled the stimulus to be executed with great efficiency.  A totalitarian government, with a priority of good for the society over individual property rights, allows for quick funding and construction of a needed highway.  Thus, China has been viewed by some as the center of the strongest future economic growth after the financial crisis.  In late 2009 and January 2010, China began tightening monetary policy, stoking fears throughout global equity markets of a decline in Chinese demand for commodities and GDP growth.  Loan growth, however, remains well above the rate in 2008 as seen in the following chart.  Additionally, concern is mounting that China may be in the midst of a growing real estate bubble, similar to the U.S. in the 2000s, as a result of increased industrialization of the economy and urbanization of the population.  

  

 

China’s status as a factory to the world relies on global demand for Chinese goods.  One risk to China’s position is a decline in this demand, which many believe can be alleviated with a shift to increased consumption by the Chinese consumer.  This will require Chinese consumption to increase from 35% of GDP, low relative to other Asian countries, where consumption is above 50% of GDP.¹¹  Consumption growth must outpace GDP growth, for the share of consumption to grow.  Starting from a low base of 35% of GDP, this will take time, and may hinder GDP growth estimates if met with a notable decline in demand from the largest importers of China’s goods.  Whether any of these risk factors could lead to a short-term decline in China or other emerging markets is uncertain, but understanding the risks taken in pursuit of the reward is essential. 

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Decoupling

 

The decoupling argument, which stated emerging markets were less reliant on developed markets for trade and thus were decreasing in risk with the expectation that these markets could stand alone, was popular with some until the global financial crisis hit and the correlation of all risky assets moved toward 1.00.  Similarly, the strong relative long-term prospects for economic development in emerging markets following the crisis may not lead emerging market economies to decouple from developed market economies.  Emerging market nations’ trade with one another, as well as the developed world, and long-term growth opportunities supported by strong underlying fundamentals makes investment in emerging markets more compelling.  This, however, does not make these economies immune from problems in the developed world. 

 

Emerging markets will continue to be a major force in the global economy, impacting commodity prices, interest rates, and employment, as low cost labor is used by companies world-wide.  Simultaneously, the U.S. economy could be less central to global growth than historically, as emerging markets continue to mature, although any shift will likely be gradual.

 

 

Current Valuations

 

After the 2009 rally, valuations for emerging markets quickly returned to more normalized, in fact elevated, levels from the considerable lows of early 2009.  With expectations of earnings growth priced into the markets, failure of emerging market companies to show this growth will be met with disappointment from investors, and perhaps a substantial decline in valuations.  One can see that emerging markets traded at over 20x earnings as of January 31, 2010, well above the historic average of 16x since 1996.  Emerging markets do not appear overvalued, however, when compared to the international developed markets.

  

 

 

As the global equity markets declined in 2008 and early 2009, investors favored less risky assets, including cash.  This trend quickly reversed when the markets rebounded in March.  Fund flows in emerging markets, however, were much more stable.  Emerging markets equities were among the worst performing securities amid the financial crisis, but these economies were much healthier as outlined earlier.  This presented attractive investment opportunities, which played out during 2009.¹²

 

 

Emerging markets are clearly in a position of benefitting from higher economic growth than developed nations.  This growth is not the key to the nirvana of equity investment, but illustrates the potential benefits to equity investors of ensuring exposure to these markets.  Much like the industrial revolution in the developed world, these economies are poised to continue developing.  Korea, while still included in emerging markets by MSCI, is considered developed by FTSE, and Korea is surely not the last emerging country to approach developed status.  As a result, we recommend investors consider a meaningful strategic allocation to emerging markets.  Current valuations indicate that a large move may not be prudent at this time, but instead a measured approach to a long-term target is perhaps more reasonable.  Investors need not rush to invest with the herd, but slowly shifting to emerging markets over the intermediate term or if there is a retreat in the market, making a more meaningful allocation may be appropriate.

 

 

¹  International Monetary Fund, World Economic Outlook Database, October 2009 (http://www.imf.org/external/pubs/ft/weo/2009/02/index.htm)

²  Population Reference Bureau 2009 World Population Data Sheet (http://www.prb.org/Publications/Datasheets/2009/2009wpds.aspx)

³  Citigroup India and Frontier Market Asset Management

⁴  Bloomberg News, “China Ends U.S.’s Reign as Largest Auto Market (Update2)”, 11 January 2010

⁵ 2006-2010 China Auto Industry Forecast, China Commodities Marketplace, ChinaCCM.com, 4 May 2007

⁶  Vivian Wai-yin Kwok, “China Car Sales Boom At Home, Forbes, 9 September 2009

^7-9  International Monetary Fund, World Economic Outlook Database, October 2009 (http://www.imf.org/external/pubs/ft/weo/2009/02/index.htm)

¹⁰ MSCI Barra Global Index Monitor (http://www.mscibarra.com/products/indices/tools/gim/)

¹¹   Pettis, Michael, “The Difficult Arithmetic of Chinese Consumption”, Wall Street Pit, 5 December 2009

¹²  Morningstar Inc., information from Morningstar Direct