Liquidity flows into emerging markets as the receding economic tide continues to expose the financial system of the developed world.
From a macro-economic perspective, the U.S. and Europe are beset by low growth relative to the rest of the global market, said Jeffery Urbina, principal of William Blair & Company, a Chicago-based investment firm.
“In emerging markets what we’ve seen is a cyclical rebound,” Urbina said, speaking to a lunchtime audience at a presentation organized by GBC Asset Management Inc. at the National Club, in Toronto. “There wasn’t a financial crisis in emerging markets; the banking systems are reasonably well capitalized.”
Emerging economies went through crises in the late 1980s and early 2000s, but have since cleaned up their collective mess. “And they did not have a mortgage problem like we saw in the developed markets,” added Urbina.
Presently, the fear of inflation looms large in advanced economies – the U.S. in particular. While the liquidity injections by the central bank in developed economies have had an impact, their ultimate effect is still unknown.
“Whether or not we end up with an inflationary environment in developed markets, because of all this liquidity injection, is yet unclear,” he said. “If the banks start to lend and the money multiplier comes back, the chances of an inflationary environment [will] certainly increase.”
While strong fundamentals continue to drive growth in emerging markets, there are growing concerns that inflation and bloated valuations could be a bit of a killjoy.
“Emerging markets continue to be relatively healthy, the growth is continuing, although the risks are increasing because of inflationary pressures,” he said. From a valuation standpoint, emerging markets aren’t necessarily any more expensive than the U.S. “The trend over the next several years is going to be that the low economic growth rates in developed markets are going to lead to undervaluation, the high economic growth rates in emerging markets are probably going to tend to lead to overvaluation in emerging markets.”
But there is an attendant risk. Observers warn of overheating as a direct result of a rapid growth environment. “Frankly the economic growth [in emerging markets including China, India and Brazil] is too strong; these economies have overheated, current account deficits are certainly coming back.”
Governments in these markets are responding to these risks by raising interest rates, which has the corollary affect of currency appreciation against the U.S. dollar, compelling governments to try and control capital flows in and out of their economies.
“We’re looking at an environment in a lot of emerging markets where you’ve got increasing interest rate environments coupled with increasing capital controls by the governments, which becomes problematic.”
Europe, on the other hand, will continue to see volatility as “there are continual questions surrounding sovereign risk, particularly in Spain, Portugal and Greece.” Urbina said while the euro will ultimately survive, investors remain anxious. “It always seems to be risk-on/risk-off in the equity market.”
The developed economies will continue to struggle through a low-growth environment thanks to broken banking systems.
“Until the banking systems in Europe and the U.S. get repaired, recapitalized, and can begin lending in any substantial way back to business, [there’s going to be] an environment that’s going to be very low growth.”
This repair work, he added, could take a couple years.
Urbina singled out Japan as an attractive market, despite the consensus that it is a losing bet.
“Japan has been a very interesting market; small-cap Japan, when you look for growth in Japan, is where you have to look,” he said. “One of the reasons we’ve become more interested in Japan of late, is the valuations are very attractive compared to other parts of the world.”
The challenge in Japan lies in balancing the portfolio between growth and valuation.
“The return levels in the near term are going to be more generated from growth, but we are going to get an environment where the valuations are going to become more and more important to us.”