As a group, emerging market equities have experienced considerable volatility, though the emerging market asset class has provided spectacular returns for investors since the early ’90s. Nevertheless, a more detailed look reveals that returns have been uneven: the ’90s have seen major shocks (the Asian crisis) and defaults (Mexico, Russia), whereas the first decade of this century saw significant outperformance compared to developed markets. More recently, emerging equities have underperformed developed markets and, as a consequence, have also seen a decline in terms of price/earnings (PE) multiple. Though correlations among emerging markets and between emerging and developed markets have increased trendwise, it should be emphasized that return differences between countries continue to be high. This dispersion—in conjunction with compelling valuations and a long-term growth story, which remains intact—implies that investors should carefully look at this asset class so as to assess whether their exposure is sufficiently high.
While the correlation of emerging markets with developed market equities overall has increased, the average correlation between the performance of individual countries has remained much lower. Over the five years to 2012, for example, this averages 0.60 for the countries in the MSCI Emerging Markets Index on an unweighted basis. This means that there should be a diversification effect from investing in different individual emerging markets.
Recent trends have seen the fortunes of individual high-growth countries diverge more than normal. The slowdown of China’s economy—whose massive investment growth in the last decade enabled many commodity-exporting countries in the universe to outperform strongly due to demand-pull effects—has been felt in the underperformance of the BRIC countries (Brazil, Russia, India and China). India has been afflicted by its own largely domestic woes, due to sticky inflation and politics getting in the way of kick-starting the investment cycle. Given the below-par economic conditions in other parts of the world, such as the U.S. and Europe, emerging countries with domestic demand focus, structural improvements or accelerating growth cycles have done better over the last 12 months.
Southeast Asian countries fell out of favour after the crisis of 1997—which hit Thailand, Indonesia and Malaysia, to name a few—and were overshadowed by the growth cycles in the mega-economies of China and India during the latter decade. Their return as an investment area of choice over the last three years— post-global financial crisis—is due to the domestic bias of economies in the region and a growing and competitive labour force, combined with the renewed vigour of political leaders, who were elected with a mandate to carry out pro-growth policies.
Indonesia, for example, has kept an exceptional rate of growth throughout and after the financial crisis of more than 6%, driven by domestic investment. Inflation has been kept at bay, enabling the Bank of Indonesia to maintain an accommodative monetary policy, which, in turn, has led to a very strong credit cycle and consumer confidence, and average annual earnings per share growth of 20%. Indonesia is the world’s 16th largest economy and is likely to significantly improve its ranking over the next decade. The vast improvement in political and economic stability has led to upgrades by the major rating agencies (e.g., Moody’s) in relation to the credit risk of Indonesian government securities.
Likewise, structural improvements are important for near-neighbour the Philippines, which, similar to Indonesia, has been able to sustain high credit growth after years of underinvestment, again from a very low base. This is supported by positive demographic trends—the young labour force and wage competitiveness are attracting inward investment, and President Benigno Aquino’s term has three more years to run, providing ample time to implement infrastructure programs through the public-private partnership model. And while valuations have increased—as the markets of the Association of Southeast Asian Nations continue to outperform those of Northern Asia—any pullback should be temporary; the domestic growth story is just too powerful in both cases. In this respect, infrastructure investments could be an interesting opportunity.
Mexico is another economy that has returned to the spotlight, especially after the election of Enrique Peña Nieto (of the PRI party) as president last year on a reform agenda that is judged to be good for economic growth prospects. Overshadowed by its neighbour to the south for the previous decade—Brazil’s economic growth having been bankrolled, in part, by demand from China due to its commodity exports—the Mexican growth story has encountered a renaissance in recent months. Peña Nieto’s election and the promise of reforms to shake up oligopolies has been serendipitous: amid anticipations of recovery in the U.S. economy, the increased competitiveness of Mexican manufacturing as a result of wage increases and currency appreciation in China has led to an about-turn of relative fortunes over the last year or so. The stock markets of Brazil and Mexico, like their GDP growth forecasts, have since moved in opposite directions.
Lastly, Turkey has been the bright spot in the European part of the emerging markets universe for several years now, which has led to very strong outperformance of its stock market in 2012. Due to the problem of structural deficits, notably of the current account—Turkey’s high growth rate means it has to import a lot of energy, though it will make investments to reduce its reliance of foreign supplies—the country has seen volatile flows from the international investment community over the years. However, the reforms brought about by the accession to power of the AK Party more than 10 years ago have led to monetary and fiscal stability, which has been supportive of financial stocks, a major component of the benchmark. And Turkey’s geographical location at the crossroads of Europe and Asia multiplies opportunities for well-organized Turkish companies—notably, construction companies working in the Middle East and the country’s national airline. These factors have contributed to strong stock market and currency performance in recent years.
As the examples show, emerging market economies are not all alike, and this is reflected in the relative performance of their stock markets and currencies. Important to note is the extent to which political change and positive political momentum have an effect on their fortunes relative to the rest of the emerging market universe. For global investors, this is one of the most difficult factors to monitor, as political situations may evolve quickly or unpredictably, with Turkey’s recent social unrest a good case in point. This implies that investors should carefully assess the consequences of any sudden political developments (stress testing for political factors) where they have invested and carefully monitor the news flows from local and international sources. Another factor that may influence the performance of specific countries concerns market infrastructure (e.g., presence or absence of globally recognized companies, depth of the market). Liquidity is particularly important as a factor: relative illiquidity can push up the PE multiple significantly higher when capital flows in, but it can also cause a big decline when the tide ebbs.
Emerging equities as an asset class have been struggling in recent years compared to developed equities. However, their attraction for the longer term is intact: sustained economic growth, increasing sophistication of local financial markets and investors, and compelling valuations. As a consequence, emerging markets benefit from higher longer-term (five years) expected returns than developed markets. Moreover, return dispersion between emerging markets provides ample opportunity in terms of tactical geographical allocation and portfolio optimization.
William De Vijlder is chief investment officer, strategy and partners, with BNP Paribas Investment Partners. william.devijlder@bnpparibas.com
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