Slim Feriani gives his take on emerging markets

Dr. Slim Feriani, CEO of Advance Emerging Capital Limited, reviews the growing appeal of developing markets.

The past decade was the worst for Wall Street since the 1930s; the S&P 500 lost 24.1% in sterling terms, which was worse than the FTSE 100 (-14.8%) and MSCI World (-17.7 %). In contrast, the MSCI Emerging Markets Index returned 102.3%. This was despite the fact the decade included the aftermath of the Asian crisis and Russian default, the bursting of the technology bubble in 2000, the Argentinean crisis in 2001, September 11, the Iraq War and SARS, not forgetting the sub-prime crisis and bear market of 2007-2009 (when two thirds of the EM index was wiped out).

We believe it is just the beginning of a structural trend which should last for some time. This performance is supported by what we see on the ground during frequent visits to our investee markets. With the gap between emerging and developed market fundamentals is as wide as ever, exacerbated by the unsustainable government debt and deficits of the latter, we fully expect this trend to continue.

Where do we go from here?

A turning point in global economy

We believe the start of the new century is a turning point in the global economy. The ongoing economic and financial crises in developed countries will be viewed as a catalyst accelerating structural change. Indeed, the balance of economic, financial and political power has already shifted significantly in favour of EM, with China in the driving seat.

Emerging countries are the “relative winners” from the subprime crisis because: (1) the quality of their sovereign, corporate and household balance sheets has never looked stronger compared with developed countries; and (2) the resilience of their economic and corporate earnings growth which is and probably will continue to be superior to that of the developed world in the medium-term.

There seems to be a growing number of investors who share this view, as judged by the record $83bn of inflows into emerging market equities last year (and another $13bn so far this year). Yet most retail and institutional investors remain underexposed to this asset class. It is estimated global mutual funds have roughly 10% in EM vs. a 13% weight in the global benchmark (now the second largest weighting after the US with roughly a 45% weight). This by no means reflects the importance of EM economies which already account for around 35% of global GDP (vs. around 25% for the US) and most of global growth. We expect the composition of future global equity indices to look very different, with the EM component becoming the largest, more in line with its global economic relevance and favourable demographics. Frontier markets will certainly be featuring more prominently as they are promoted to replace those EMs that “graduate” to developed market status, just like Hong Kong and Singapore have done.

The bubble risk

Absolute and relative valuations are by no means stretched. The latest figures from Morgan Stanley show the forward P/E multiple for EM is 9.6x, i.e., a 10% discount to developed markets and 25% discount to their own historical average. Aggregate ratios for frontier markets remain hard to come by, but both the Middle East and African continents appear to be trading at single digits too. We do not treat lightly the potential for a bubble to develop in EM markets over the next one to two years, as global investors continue to catch-up with the growing importance, influence and attractiveness of EM. This bubble risk is even bigger in frontier markets because they are much smaller and less able to accommodate rapid capital inflows than their “mainstream” emerging counterparts. For this reason frontier markets are often “perceived” as risky; we view it is part of their appeal, but something that will change as those markets develop and deepen.

We often quote copious numbers and statistics to try to convince the sceptics the secular bull market in EM is robust. Things are very different in EM today compared to the late 1980s, when they were grouped together into a “new asset class” by index providers and reference to “third world” had become politically incorrect. Today’s reality is the BRIC countries and EM are for real and far less dependent on the US than the market thinks. Last year China overtook Germany as the world’s largest exporter and surpassed the US as the largest global auto market and will overtake Japan this year as the second largest economy. China has become the main trading partner of most EM and has also contributed to improving the economic outlook for Africa via significant FDI and trade.

But of course there are risks.

The future of the eurozone is being questioned by politicians eager to appear decisive but equally anxious not to fall out with their voters – never a recipe for action. In China, rising actual inflation and inflation expectations as well as property prices are triggering rapid monetary tightening. The ongoing sharp moves in currencies are concerning. While a premature withdrawal of monetary and fiscal stimulus leading to a “double dip” recession in some economies like the US remains a dangerous possibility.

We live in a world of uncertainty and risk remains an integral part of investing. Of course there are major uncertainties in the world today and they need to be balanced against what we perceive to be the attractions and opportunities inherent in emerging markets.

A positive future

Notwithstanding the risks mentioned above, which are primarily of a short-term and cyclical nature, we believe the prospects for emerging and frontier markets remain positive. All of the above makes us very positive about the future for EM markets, which are in a virtuous cycle where increasing stability breeds confidence and confidence breeds success. We are encouraged by the fact the EM growth story is not a zero sum game and its expansion is not at the expense of, but benefits greatly, developed economies. Well-diversified portfolios should be positioned to benefit via a sizeable allocation to emerging markets.