While investors remain focused on the ongoing sovereign debt crisis in Europe, emerging markets are going from strength to strength. The Banker asks a group of emerging market investment specialists about new sectoral trends and where the next wave of growth is coming from.

The participants:

  • Claudia Calich, head of emerging markets debt, Invesco
  • Rahul Chadha, head of Asia-Pacific investment division, Mirae Asset Global Investments (HK)
  • Roberto Lampi, head of emerging market equities, Barings
  • David Wickham, director, global emerging market equities, HSBC Global Asset Management

Can emerging markets withstand the ongoing European sovereign debt crisis?

Claudia Calich, head of emerging markets debt, Invesco: Emerging markets can withstand the ongoing crisis as long as the crisis remains concentrated on the smaller economies. The economic impact of the peripheral European economies on emerging markets is small, because of their relatively small size. As such, emerging market exports to those economies are small, as well the size of their investment flows into emerging markets. Emerging market banks do not have direct exposure to European periphery debt, which protects their balance sheets. However, should a large European country require financial assistance or should the economic growth of the core countries be negatively impacted as a result of the developments in the periphery, the impact on emerging markets will increase.

The issues 

  • Sovereign debt crisis
  • Rising inflation
  • Returns from emerging markets
  • Asset allocation
  • Areas of growth

Rahul Chadha, head of Asia Pacific investment division, Mirae Asset Global Investments (HK): I think the story in emerging markets is fairly resilient, given that even during the worst of the financial crisis in late 2008 [and] early 2009, the economies in most of these countries grew a relatively healthy 5% to 6% in gross domestic product terms. The long-term story of higher GDP growth on the back of favourable demographics, increasing per capita income and rising consumption remains intact. However, I must admit that if financial conditions come to a complete standstill again, as they did for a time in September 2008, there is bound to be a temporary impact on emerging markets also.

We live in a globalised world, so it’s not fair to say if there’s a huge crisis in one part of the world emerging markets would not be affected, since there are trade flows that interconnect all the regions. However, we [Mirae Asset Global Investments] believe that policy-makers have displayed ample maturity to handle this crisis, and lessons from the Lehman Brothers crisis have been learned well.

The best case for markets is that liquidity/monetary supply remains accommodative and we have credible, time-bound, fiscal consolidation plans for countries in Europe and the US. Once this is done, we may see investors return to focusing on fundamentals and valuing companies appropriately.

Robert Lampi, head of emerging market equities, Barings: The economic stress in European debt markets and speculation with regards to a soft landing in Europe and the US, coupled with a rebound in Japanese activity after its devastating earthquake, have led to a great deal of uncertainty in recent months, resulting in volatility.

We [Barings] do think, however, that investors are increasingly able to differentiate between emerging economies where the fundamentals are essentially strong and the much weaker position of many Western ‘developed’ markets. In the quarter we've just been through, for example, it was the emerging countries whose growth dynamics are less dependent on the global cycle and are driven more by their domestically led consumption and investment which were the best performers, and it is in these countries that we see particular opportunities at present.

David Wickham, director, global emerging market equities, HSBC Global Asset Management: We expect global emerging market equities to generate solid returns in 2011 as investors realise that many emerging market countries are much safer than their debt-challenged eurozone counterparts.

How much of a concern is rising inflation in emerging economies?

Ms Calich: It is a concern in countries that are growing at or above potential [parts of Asia and Latin America] and/or countries that are more exposed to rising commodity prices. This has prompted central banks to embark in monetary tightening. We [Invesco] expect inflationary pressures to stabilise as growth in emerging markets moderates in 2011. The recent broad declines in commodity prices should also help.

Mr Chadha: Rising inflation is an issue that has dogged emerging markets for about 12 to 15 months now. Although some of these countries have seen output gaps being closed, we must also understand that a large part of the inflation up-tick in many of these markets is a creation of government policy.

In China, for example, the government has shown it is far more comfortable with higher wage growth, and what this means is that the buying power at the bottom of the pyramid is much higher, and you have more demand chasing fewer goods. Similarly in India, the government has raised minimum prices for certain crops, and we have had increased wages at the lower level. Naturally, this has seen an increase in inflation.

The central banks in these countries are cognisant of these changes and have been far more accepting of higher levels of inflation than before. On the other hand, governments are also cognisant of the fact that runaway inflation is the single biggest risk for these markets. We believe with global growth tapering off we should see the peak of inflation in these economies in the next three to six months. Next year, base effects will kick in and we should see much lower levels of inflation.

Mr Lampi: Inflation is undoubtedly still a risk across the emerging markets, but central banks in China, India, Indonesia, Brazil, Turkey and Peru have been active in tightening monetary policy in previous months, and – in marked contrast to the developed Western economies – are now nearing the end of the tightening cycle. We believe this will provide potential for a significant positive shift in sentiment towards the emerging universe.

Mr Wickham: Inflation is one of the most pressing issues facing the emerging world, and indeed the developed world. The ability to manage inflation on the back of the monetary policies adopted by the US and eurozone governments to contain the effects of the global financial crisis without impeding economic growth will continue to pose a key challenge. To date, we have seen a range of policy responses enacted across the emerging world in an attempt to tackle inflation, with differing speed, strength, and success.

In Asia, for example, the Chinese and Indian central banks have implemented numerous interest rate hikes and reserve requirement ratio increases in a bid to restrain inflation and, in our opinion, the monetary tightening cycle in these two countries is nearly complete so inflation is likely to peak in the near future.

Now that many emerging markets have in fact 'emerged', which countries are the next ones to watch and why?

Mr Chadha: The long-term story of strong demographics and strong demand still remains in countries such as China, India and Indonesia. We remain particularly positive on these countries from a three- to five-year perspective. Demand will likely continue to surprise on the upside. Outside Asia-Pacific, we continue to like countries such as Russia and Brazil in terms of their longer-term prospects.

Recent times have seen a spate of corporate governance concerns, particularly for some Chinese-listed companies in the US. However, we believe large bellwether stocks have relatively reasonable levels of governance standards. Corporates across the region are emulating the best practices of their global peers, which over the medium term should provide increased comfort for investors.

Mr Lampi: What makes emerging markets attractive for us is the prospect of rapid economic development, where cyclical growth and structural changes combine to create attractive investment opportunities as GDP per capital rises. Our investment universe is defined by [investment decision support tool provider] MSCI, but some of the frontier markets in south-east Asia, Latin America and the Middle East and north Africa region have long-term potential provided they meet our liquidity and investability criteria.

Mr Wickham: Growth in the world is now clearly led by emerging markets. As such, there is still an abundance of stock specific opportunities for equity investors in the core emerging markets such as the BRIC [Brazil, Russia, India and China] countries.

Outside the core emerging markets, there are also increasingly compelling opportunities in a number of the smaller emerging and frontier markets, such as those within the CIVETS [Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa] grouping, due to a combination of favourable demographics, increasing urbanisation, sound fundamentals, and the introduction of investor-friendly reforms.

How do you expect to change your asset allocation over the coming months and why?

Ms Calich: We don’t expect major changes but are monitoring the risks in the developed markets closely (in addition to the European debt issues, the fiscal outlook and pace of economic recovery in the US). We continue finding selective opportunities in emerging market local currency debt (Asia and Latin America), emerging market corporates and sovereigns.

Mr Chadha: We are currently more positive on China, because valuations remain attractive and we believe that inflation concerns should ease over the next two to three quarters. Russia is also attractive because of valuations and the effects from stronger commodity prices recently.

Outside of this, we expect to see the peaking of bad news in India over the next three to four months. India is currently trading at the low end of historical valuations, the growth story remains strong, and we should see an end to recent policy paralysis. India remains a large market where we would be looking to increase weight over the next six to nine months. We also continue to like Indonesia as a good long-term story, and overweight this market on the back of its strong demographics and rising per capita income. 

Mr Lampi: Our investment strategy is to identify the countries where we see the most conducive conditions for positive news flow and upgrades of corporate earnings expectations, and then to seek attractively valued companies with strong business operations that we believe will most benefit from this supportive top-down environment.

We're positive on China, due to very attractive valuations, inflation peaking, and good growth expectations. Indonesia is also preferred as we see the economy being re-rated as the government has done an exceptional job managing both fiscal and monetary policy. Domestic growth factors remain very strong.

Elsewhere, we have become more cautious on South Korea and Taiwan, mainly due to their exposure to global growth. Malaysia offers attractive exposure to stocks with a strong Asean [Association of South-east Asian Nations] growth component; these stocks are either in the financials or discretionary sector.

Our valuation discipline is a critically important part of our investment process and we continue to see Chile as generally looking expensive when compared to other emerging market stocks. Brazilian stocks looked less expensive compared to their history, which prompted us to increase our holdings in this country. We see attractive value in Russia, but predominantly in domestically orientated stocks. Although Thailand and the Philippines may look attractive, we feel that country risks offset valuations in these markets. 

It remains our view that full normalisation of developed market monetary policy, probably marked by successive rate hikes in the US and other core developed economies, will mark the end of the trend of strong emerging market equity outperformance, but this is not our core view and we expect good absolute and relative performance from the emerging market equity asset class in 2011.

Mr Wickham: Our outlook for the remainder of 2011, based upon valuations and expected profitability from a bottom-up fundamental perspective, is that markets such as Russia, Turkey, South Korea and China will outperform and this view will undoubtedly be reflected in our allocation.

In Russia, for example, the market is trading at incredibly attractive valuations (relative to both its own history and broader emerging markets), with companies forecast to deliver strong earnings, which have been boosted, in turn, by high commodities prices  (Russia’s index is two thirds commodities linked.) In China, we especially see value in sectors such as industrials and financials in light of recent tightening-induced market weakness.

Which sectors have seen growth in 2011 and which countries’ financial sectors are attractive?

Ms Calich: Emerging market financial sectors have benefited from improved oversight and supervision after several banking crises in the 1980s to 1990s and from the macroeconomic stability of their respective economies. While a few countries were under pressure in 2007 to 2009, most financial sectors were able to navigate through the global financial crisis. We see opportunities in Brazil, Russia, Peru and Turkey.

Mr Chadha: At the beginning of 2011 we saw a rally for commodities prices as fears of a sharp collapse in global demand faded and there was some catch-up given that the sector had been trading at a discount. Consumption as a theme continues to do well across markets, although within this space we have seen a shift towards the higher-end of the consumption basket, even though autos are taking a slight breather after a strong two years. In terms of financials, we like them in Indonesia where credit-to-GDP is still a low 30% to 35%, and still has a long way to go in terms of credit penetration levels per capita. Non-performing loan levels within the financial sector are still sub-2.5%, approximately.

We would also be looking to increase our exposure to financials in India and China as inflation peaks out in the next six months in both countries, and the sector has been long ignored in and underweight in most portfolios. And given resilient GDP growth of at least 7% to 8% across most of these markets in recent months, many people will realise again that banking is the best proxy to play this growth.

Mr Lampi: With strong domestic growth, we see good potential in some more staples, discretionary and industrial firms benefiting from a domestically led growth economy. We also hold exposure to globally orientated stocks. These are of the higher quality type with a proven business model and viewed as the winners within their sector. These are in India, South Korea and Taiwan in the IT and industrial sectors. We have decreased our exposure to energy in Russia due to valuation, while added more in the discretionary sector in Brazil, India and Malaysia. In the materials sector we have biases towards bulk materials (such as iron ore and nickel), and also to copper.

Mr Wickham: At present, our principal overweight sectors include financials, industrials and consumer discretionary. Within financials, we presently see particular value in Chinese, South Korean, Russian and Turkish financial companies. The financial sector is, not surprisingly, an excellent proxy to play expanding domestic growth.

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