Over the past 10 years ending 31 March 2002, the MSCI Emerging Markets Free Index is up 23.6%, while...
Over the past 10 years ending 31 March 2002, the MSCI Emerging Markets Free Index is up 23.6%, while the MSCI AC World Index is up 140.3% in sterling terms.
This underperformance looks even worse over the past five years, when emerging markets have fallen 21.3%, while the world index has risen 37.1%. It is only since the third quarter of last year that they started to outperform and even then it was by no great margin.
The original rationale to support investing in emerging economies was that they provided superior growth while diversifying risk in a global portfolio. After the 1994 Mexican crisis, 1997 Thai crisis and 1998 Russian crisis, this rationale has proved woefully wrong.
It is important to consider what have been the main failings in emerging markets. The first has been poorly financed current account deficits that have lead to regular currency crises. This situation has radically changed in that current accounts are generally in surplus now, especially in Asia, which accounts for more than half of the index. Where deficits are in existence or surpluses are expected to erode, it now appears that risk is substantially reduced as they tend to be backed by historically high FX reserves. Reserves are benefiting from strong foreign direct investment, rather than relying on volatile short-term portfolio investment.
The second failing has been profligate lending by weak banks to low quality borrowers. This has improved through the globalisation of finance and the penetration in all three regions by Western banks that have brought fresh capital and stricter practices. Improving corporate governance and laws of restitution have led to a huge clear-out of bad debts, leaving banks able to lend once again. A shining example is Korea, the largest constituent in the index, where non-performing loans peaked at more than 40% and are now 3%. Better quality corporates have emerged after the crises and returns on equity have burgeoned to levels above mature markets and should lead to a re-rating of the markets.
The third failing is an over-reliance on exports. This has been mitigated by a surge in consumer demand as high savings rates have unleashed a much-vaunted jump in domestic demand as confidence rises on the back of historically low inflation and interest rates.
The improvement in economic fundamentals has been reflected in emerging market bond spreads, which have fallen to pre-crisis levels of about 6.5% over US treasuries (having been as high as 16%) and which are now nearing lows of 4%. But it appears to be the equity markets where the opportunities lie due to the cheaper financing, lower risk aversion and improving confidence. All global equity markets have risen since 11 September but good value and growth sets emerging markets apart.
They carry a P/E of 12 with 21.7% EPS growth or 2003 versus the global benchmark on more than 20 with half the growth. The largest markets should be the core for exposure as the six largest markets account for almost three- quarters of the index and are likely to be targeted by global investors who are believers in a world recovery.
Economic fundamentals are much healthier.
Markets are good value and growing well.
Outperform when OECD leading indicator rises.
Partner Insight Video: Advisers have had to adapt to the changing investment landscape.
Investment trust savings scheme