“The largest economies in Asia are actually amongst the least sensitive to growth in the United States,” he says. “I want to suggest that the laws of domestic demand and consumption in emerging markets in Asia will see them through this period.”
“There will be a slowdown in growth over the next while, probably in the neighbourhood of 50 to 100 basis points. Just to give you an idea of the extent of China’s domestic demand, it installed the electricity generation capacity of the United Kingdom last year alone.”
It’s the decoupling that makes emerging markets a necessary asset class for diversification since their returns will be somewhat uncorrelated to those of developed markets. Hoguet warns that emerging markets can’t be viewed in one broad sweep. The best way to invest is to examine each sector and company on a case-by-case basis.
“The reasons for investing in emerging markets is really diversification and a growing investment opportunity set,” he says. “I’m really very surprised as I travel around the world, how many large pools of capital are structurally underweight emerging market equities. I don’t know if it’s because of the trauma of 1997/1998 [currency crises], but an asset class that has increasingly become mainstream is still being viewed as exotic and risky.”
Hoquet notes that many pension plans remain hesitant to increase their exposure to emerging markets because they are not getting the 1% to 2% premium on their long-term emerging market positions.
“Some plan sponsors put in a 1% to 2% premium in their long-term asset allocation for emerging market equities. I would like to suggest that return premiums are indeterminate because you don’t really have a long time series,” he says. “In the long-term, stocks should return about 6% over inflation. Emerging market stocks, some people say return 7%. Even in the absence of a return premium people should invest in emerging market equities because more diversified and you will have a more stable portfolio.”
Hoquet also adds the credit risk, particularly on larger companies based in emerging markets, is actually being upgraded during a period in which global equities are being downgraded. While this is good news for investors in those companies, it can make index investing in those regions problematic for investors opting to get their exposure to emerging markets through exchange-traded funds that track benchmarks like the MCSI Emerging Markets Index.
While index companies have gotten better at selection criteria, he says, they can still lead to misleading classifications.
“MCSI is rebalancing to consider putting Israel and Korea into developing markets. They are thinking of demoting to the frontier class Colombia because of capital controls, as well as Pakistan. They are thinking of taking the Gulf Cooperation Council markets that are awash with [oil] cash and taking them out of frontier and into emerging markets,” he says. “From an investor’s standpoint, what we own is more important than the way we classify it. The structural characteristics of the Korean market haven’t changed just because the MCSI classifies it as one market and changes it to another.”
Hoguet explains that many of Korea’s characteristics remain on par with those of emerging markets. They have very serious political and security threats and relatively weak financial institutions. Therefore, he wouldn’t want to give it the same risk characteristics as developed markets. Even in developed markets, institutional weakness in the ratings agencies was partly responsible for the sub-prime crisis. These risks are magnified in emerging markets.
“What really defines an emerging market is not so much payout of income but the strength of its institutions. I think that a benchmark provider needs to take into account those factors,” he says. “Indexes have enormous and, I think, disproportionate influence in terms of the flows of global capital. What are people structurally underweighting? If Korea migrates from emerging markets to developed status, that means there’s going to be a net inflow into Korea.”
He adds, “I actually think the freeze-up in liquidity that we’ve seen, for example, in the mortgage market could happen in the emerging markets. We’ve seen tremendous push factors leading to trend following, leading to flows into emerging markets. We could see a situation where the global environment is dramatically incapable of continuing this.”
Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com