Low valuations, diversity and reduced political risk helped emerging markets outperform their more developed peers in 2002 and should continue to provide a boost over the forthcoming year
Emerging stock markets out-performed those of the developed world during 2002, helped by falling interest rates in the US and Europe, which increased the relative attractiveness of riskier asset classes.
The MSCI Emerging Market Index fell 20.2%, compared to a drop of 31.7% for the MSCI World Index. This outperformance continued in January 2003, despite a widespread retreat by investors into quality safe havens such as US Treasuries as the 'war risk' premium increased. We believe the factors that have supported this outperformance will persist throughout 2003.
World-class companies in emerging markets, often with faster earnings growth than their developed-market peers, are on low valuations. This is reflected in low stock market valuations as a whole. For example, the Czech Republic's PX50 index is on a trailing P/E of 11 times, South Korea's KOSPI is on 10.7 and Mexico's IPC is on 12.9. This contrasts with 38.3 on the S&P 500, 33.1 on the Nikkei 225 and 13.1 on the FTSE 100 (source: Financial Times).
Investing in emerging markets allows the investor ample opportunity to spread risk. Diversification comes from the low correlation between sectors as well as regional themes.
The fortunes of a semi-conductor plant in Taiwan, whose profits are linked to the volatile demand for technology products, have little in common with the successful privatisation of a utility in the Czech Republic.
Eventual EU membership has spurred policy reform in eastern and central Europe, contributing to a better investment climate and, in turn, to economic growth. Stock, bond, and currency markets have all benefited. Macroeconomic fundamentals in many of the entry class of 2004 are currently stronger than those of France and Germany.
Emerging markets have long been seen as a leveraged play on global growth as they supply primary and, increasingly, manufactured goods to the developed world. But the profits of this activity are now generating internal demand, as trade barriers fall and western goods and services generate competition.
China is the most startling example of this process. Although it remains nominally communist, its strong economic growth over the past decade was driven by its competitiveness in global business.
China is becoming the world's manufacturer. This profitable activity has enabled domestic demand to grow rapidly in recent years and to speculation of a currency revaluation. Its growth is underpinning regional trade.
While China has a very stable political regime, upheaval caused by more unpredictable nations has caused problems in the past. However, political risk has been reduced in Turkey and Brazil following recent elections in both countries, which apparently non-business-friendly parties won. The Islamicist-biased AKP and President Lula de Silva PT Workers Party have both shown a determination to keep to IMF agreements and implement important reforms.
Certainly, there are problems. Argentina and Venezuela require a new breed of politician as well as reformed banking systems. However these countries have little weighting in Latin American, let alone global emerging market, portfolios.
North Korean and Chinese saber rattling will occasionally upset South Korean and Taiwanese financial markets, while South African labour market reform could yet kill the goose that lays the (literally) golden egg. But these problems are disconnected; there is no reason to link them to an overall view of emerging markets.
Looking at Asia ex-Japan,our preference is towards companies with strong, stable and visible cash generation, preferably also paying a good dividend, at the expense of property companies and the region's banks.
We are overweight Hong Kong because of the dividends available from its utility sector, as well as holdings in China-related stocks. Korea is another overweight.
We are underweight China itself, due to the difficulty of finding stocks in which to invest directly, as well as Indonesia and the Philippines. We are neutral Taiwan, Singapore and Thailand.
The US and global economic outlook continues to be an important factor for investor sentiment, as Asian stock markets are weighted heavily towards cyclical sectors and exporters. The geared status of the region's stock markets to global growth should help it this year, as we anticipate a recovery in overall demand in the major economies.
A weak dollar is likely to have only a marginal impact on the region's economies as, in helping to stimulate US capital spending, it will boost exports to America. In addition, the region will benefit from growing domestic demand in China. Stock market valuations are attractive, particularly in the mid-cap arena.
The current debate about regional deflation, with some pointing the finger at China, misses a key point. The bank debt-induced deflation of Japan is different from the manufacturing competitiveness deflation of China, which is a continuation of a structural trend towards lower real prices that began with the Industrial Revolution in Europe. As such, it is relatively benign as resources are freed up elsewhere for more profitable activities and economic growth accelerates.
On the other hand, Japanese debt deflation inhibits overall demand because banks are afraid to lend and risk weakening their balance sheets further. This limits economic growth. China does have a bad debt problem in its banking system but this has not noticeably affected investment.
The outperformance of emerging markets seen in 2002 should continue.
Future EU membership of Eastern European markets is leading to a better investment climate.
Political volatility has become less of a problem in many emerging markets.
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