Though the returns from Brazil, Russia, India and China's emerging economies speak for themselves, their bubble may be about to burst. Smaller emerging markets could be about to pick up the baton
Although returns from Brazil, Russia, India and China (Bric) have outperformed emerging markets indices by 13% this year, with an economic slowdown expected for 2007 prospects may not be as good.
Investors have been attracted to Bric funds because they believe the large size of these economies will produce robust growth. However, this is a false security. Although the prospects for emerging markets for 2007 look good compared to the developed world, investors should understand what drivers have propelled each economy to achieve growth.
Each Bric country does not perform in line with each other and will respond differently if a slowdown occurs. Countries such as China and India, which are more dependent on the global economies for growth, may suffer more in a slowdown than the less reliant Brazil and Russia.
Investors may be better off diversifying their portfolio and investing in smaller emerging markets less likely to be impacted.
China: hidden dragons?
For example, China is the most lauded example of an emerging market benefiting from globalisation. The country has enjoyed substantial job creation and wage growth, which has fuelled disposable income. Bank liquidity has surged due to the flush of deposits. Credit growth is high with the country having one of the highest credit-to-GDP ratios in the world.
However, the lack of liberalisation and reforms on a number of fronts in China has weakened the domestic economy in the event of a substantial slowdown. For example, the state ownership of most Chinese banks has led to a moral hazard - the idea the government will bail out banks if loans are unpaid. This has meant much of the credit growth has been allocated inefficiently or in non-performing loans. In addition, production overcapacity is threatening the profitability of a number of investments and is putting pressure on the return on capital invested. Banks have responded by investing more to improve their chances of recovering the capital.
A slowdown in the US and Europe in 2007 is likely to put pressure on China's export prices, which would reduce the return on capital even further, possibly enough to expose the weakness of loans.
Problems in the Chinese economy are not limited to the banking system. The low renminbi and capital outflow restrictions may also hamper the efficiency of the economy or could create bottlenecks. If a slowdown occurs in 2007, this situation may only worsen.
India: trading at a premium
India has taken a similar path to China in terms of consumption, investment and exports. Although India is more financially soluble due to better corporate governance and a far more de-nationalised banking system, it will still be impacted by a slowdown.
Corporate earnings are starting to moderate after growth of more than 30% over the past three years. As a result, Indian equities are trading at a substantial premium to global emerging markets, which may lead to high volatility as earnings come under pressure in 2007.
Brazil: equities on the rise
Contrarily, Brazil will be less impacted by a slowdown because economic growth is dependent on commodity stocks, which will still enjoy global demand. As far as Brazil is concerned, demand is mainly for agricultural goods and metals particularly iron ore. The industrialisation trend among emerging markets - not just China - is likely to ensure strong commodity demand is maintained, to the benefit of Russian and Brazilian equities. In this sector valuations are still not stretched, due to robust earnings growth.
But the real investment story in Brazil is its declining interest rates. So far in 2006, interest rates have been cut by 3.75 percentage points to 14.25%. Diminishing inflationary pressures are likely to send them even lower. Lower rates are likely to encourage investors to switch to equity markets, which will benefit the Brazilian equity market.
In addition, the Brazilian market is trading at a discount to emerging market peers due to its non-investment grade status. This is likely to be upgraded either in 2007 or 2008, which is already starting to be factored in by investors.
Elections planned for October are less likely to cause volatility than those of neighbouring countries, as the economic policy is not expected to change dramatically.
Russia: earnings under pressure
Russia will also be less impacted by a slowdown. The country has become a far more stable economy, with strong oil prices allowing the state to make advance repayments on its debt. Foreign debt has fallen from more than 100% of GDP to just 20%. The economy is also benefiting from spending on infrastructure and consumer.
Demand for oil is likely to remain strong, supporting the current oil prices and company earnings. As private consumption has increased, so has the number of non-oil companies on the Russian equity market, though many are indirectly dependent on the price of oil.
However, there are still fears for the Russian economy. Despite the portfolio investment potential, the country's high inflation and strong rouble are a source of concern, as they are likely to put earnings growth under pressure. The government's corporate-unfriendly activity is also a negative.
Although Bric countries are undoubtedly the largest emerging economies, their size is no guarantee of performance or security. These economies have widely diverging investment outlooks as markets decelerate in 2007. Other areas for investors to look for could be the smaller emerging markets.
The flip side of globalisation is the need among developed countries to outsource to ensure the economy has a constant flow of cheap goods in order to maintain a higher standard of living. And while a slowdown in 2007 may put pressure on prices, it is unlikely that the demand for cheap products will dry up. Indeed, demand may increase as companies in developed countries are pressured to move production facilities to emerging markets to cut costs.
Export demand may move to other, less expensive emerging markets, particularly if China succumbs to the pressure to raise the renminbi. This would open up smaller emerging markets to the globalisation trend such as Vietnam and Indonesia.
Overall, investments that look closely at each emerging market can offer better performance and greater security than blanket Bric investments. China and India reveal a slightly gloomier picture, while Brazil and Russia are positioned to continue to outperform. For investors targeting a diversified portfolio, they should not overlook small but promising emerging markets such as Indonesia, Mexico, Columbia and South Africa. A global emerging market equity fund offers more. key points
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