Emerging markets growth: Fact or facelift?

She’s a participant in the current online CIR debate on whether emerging markets offer superior returns.

“Currently, emerging markets market cap is approximately 13% of the world as measured by the MSCI All Country World benchmark,” she notes. “The current GDP contribution from emerging markets is 39% at purchasing power parity, and the IMF estimates this will increase to 43% by 2014.”

For investors, she adds, “I see many structural growth stories in emerging markets. The link between emerging markets and natural resources is well known, and emerging markets have certainly gained from the surge in commodity prices globally over the last 10 years (in part due to growth in emerging markets themselves: urbanization trends, infrastructure improvements, etc.). However, some of the next-leg stories can be found in other sectors, in trends that are still nascent in many countries. “

Guest analyst Cam Harvey argues that “the overall level of risk is approximately the same today as it was 15 years ago. On one hand, risk has been reduced as many EM economies have become much more developed and better organized. In addition, country-specific liquidity risk has decreased. On the other hand, correlation risk has increased. EMs are more closely linked to world markets and to each other. The net effect of the risk reduction due to economic and financial development and the risk increase due to higher correlation is probably zero.”

But he also moves the discussion into another dimension. “If there is an opportunity for superior performance, it comes from active investing. There are plenty of pockets of opportunity that can be exploited by active strategies. While performance dispersion across markets has decreased, the level of dispersion is still high relative to DMs, which means investment opportunities for active managers.”

On the pro side, Paul Kapsos says higher risk has indeed been rewarded. “From Jan. 1, 1988, DM made 6.7% p.a. with a standard deviation of returns of 15.3%. EM returned 13.4% on a 24% standard deviation, roughly 2x the relationship you note. The ratio of return to risk (a simplified Sharpe ratio) is 0.45 for DM and 0.55 for EM. So EM, while certainly riskier, also earned a better return on that risk. If EM had the same ratio, it would have made just over 10%, so 80% of the higher returns are from higher risk, 20% (or 2.8% p.a.) from better return on risk.”

While he sees growth decelerating at some point, “determining whether the current premium in EM stocks already anticipates that higher economic and cash flow growth is harder to say.”

Against that, Mark Williams thinks “emerging market countries have gotten a marketing facelift. … Such a name sounds safe and full of investment opportunities yet it is an investment fallacy to assume less developed will become more developed.”

There may be opportunities, but he sounds a note of caution on emerging markets as a whole. “All emerging market equities are not equal in risk. Investors need to pick and choose carefully. Using ETFs can help but even the BRICs are not a guarantee for above-market returns. Last, while many emerging market bulls speak to the long-term growth trend of this sector, most of the growth is being fuelled by foreign investment.”

These discussion points lead debate moderator Adam Bowers to introduce two more:

“1. There has been talk of a “valuation bubble” in emerging market equities, but when you compare P/E ratios of EM to DM, you see very little difference. For example, the P/E ratio of the Canadian stock market (19.1 times earnings) is actually higher than that of Brazil (15.6), Korea (13.9), Taiwan (15.1), Shanghai (17.7). Other developed markets such as the U.S. and Germany have P/E ratios of about 15 times earnings.

“2. Shouldn’t we be concerned with where a company derives their revenue rather than the country of incorporation? For example, Standard Chartered PLC is a financial services company that is incorporated in the U.K. and is part of the developed market index, but derives the majority of its revenue from Asia, Africa and the Middle East.”

To add your point of view, go CIR Debates Online.