An optimistic outlook for global emerging markets may be a little presumptuous, but with a careful stock selection process in place, low risk good returns can be achieved
There is reason to be cautiously optimistic about the outlook for emerging market equities, given the background of improving global economic growth. Following closely from that, however, is the recognition that not all regions and sectors will benefit equally, and it is therefore critical for performance to identify the specific areas of relative strength.
Looking first at Asia, the strength of the Chinese economy has been the principal driver behind the region's growth during 2003, providing the impetus for the strong intra-regional trade that supported many of its economies at a time when global recovery was only just emerging elsewhere. Within the region, it is expected that China, and increasingly Japan, will remain as the dominant growth drivers for some time.
However, the very strength of China's economy and equity market in 2003 has begun to create some potential issues for investors. Most obvious, perhaps, is the fact that valuations have become somewhat stretched as a result of the market's rally, a factor that should prompt investors to adopt a more cautious view on the market's outlook near term. The renminbi's peg to the weakening US dollar has undoubtedly helped China's exports, but there is now mounting speculation the currency will be repegged at a higher rate, removing some of its competitiveness. In our view, these factors should lead to a change of emphasis for investors - moving away from the cyclical and export-orientated stocks that performed so well last year towards those more likely to benefit from the rapid growth in consumers' level of disposable income.
Elsewhere within Asia, the prospects for Malaysia and smaller countries such as Indonesia are particularly positive. Both are well placed to benefit from a significant broadening of economic activity within their domestic economies as monetary policy remains accommodative. In Malaysia, for instance, it is anticipated the economy will expand in excess of 6% per annum over the next few years and there are encouraging growing signs of political reform and implementation of sound pragmatic economic policy. These have prompted the upgrading of the country's credit rating and led to growing interest from overseas investors.
Exposure to the financial sectors of these countries is one of the most rewarding ways of gaining exposure to this theme, as expanding economies lead to strong growth in lending. Banks such as Public Bank in Malaysia and Bank Rakyat and Bank Mandiri in Indonesia offer the strength of franchise and potential for growth that can lead to positive earnings surprise. However, it is still important to distinguish between the strengths of the sector in different countries. For example, although a strong GDP growth outlook for Thailand remains intact, it is possible bank valuations there already reflect an optimistic outlook for loan growth and diminishing provisioning levels. In addition, recently announced plans to encourage consolidation within the banking sector could translate into government controlled banks merging with private banks under less than favourable conditions for minority shareholders.
In contrast, there is more reason to be positive on the outlook for banks in Taiwan and South Korea. The recently published fourth quarter results of South Korean banks such as Hana Bank and Kookmin Bank were particularly encouraging, showing stronger than expected margins, loan growth and fee income, although their bottom line was hit by high provisioning levels as a result of the LG Card crisis. It is expected the upturn in Korea's GDP growth to accelerate in the second half of 2004, with banks' operating earnings continuing to rebound while provisioning levels decline.
Throughout the region, it is expected the increasing global trend towards outsourcing will provide support, and portfolios should begin to move away from the raw materials stocks that performed so strongly last year and focus on companies delivering value-added products or services such as Taiwan Semiconductor in Taiwan. Nonetheless, exposure to resource stocks such as Indonesia's Perusahaan Gas, which looks set to benefit from the strength of contracts it has signed with other Asian countries, remains an important feature of investment in the region.
Turning to Latin America, Brazil and Mexico will present some of the best opportunities for investors in emerging market equities. Political and corporate governance reform is particularly evident in Brazil, while the prospect of further cuts in interest rates renders it especially attractive in comparison with many of its emerging market peers. However, with rates already down from 26.5% in February last year to their present level of 16.5%, it is expected further progress in this direction is likely to slow. Indeed, January's decision by the Brazilian Central Bank to keep interest rates unchanged in view of an increase in inflationary pressures certainly put a temporary stop to the equity markets' prolonged rally.
From an investor's point of view, however, it is expected this represents a good opportunity to raise exposure to Brazilian equities, since the underlying expansionary background to provide further support for the domestic economy, and hence an increasingly positive background for equities. Stocks that should offer the most potential include aircraft maker Embraer, electric utility CEMIG and Petroleo Brazilieros (Petrobras) which, according to analysis, boast strong franchises and the ability to deliver high quality earnings growth.
The Mexican market lagged Brazil's in 2003, in part due to uncertainty with regards to the real strength and sustainability of the US economy's recovery, notably during the first half of the year. As further encouraging data emerges from the US, Mexican equities will post an increasingly strong performance, given the country enjoys particularly close links with the US. In addition, low domestic interest rates should stimulate housebuilding and other industries focused on the domestic economy. Indeed, recently released figures have demonstrated robust growth in retail sales and more positive news on unemployment and consumer confidence.
Europe, Middle East and Africa
In our view, the emerging Europe, Middle East and Africa regions present fewer opportunities for investment. To begin with, there is concern that the economic uplift that will occur when European Union membership is confirmed on Eastern European countries this year, is already adequately reflected in equity market levels. Rather, there is some scope for negative surprise, as these countries will have very little room to manoeuvre if the transition to monetary union proves challenging to their management of budgetary criteria. As a result, exposure should only be limited in these countries, with investment focused on Hungary through stocks such as OTP Bank, which is looking to grow earnings through expansion into neighbouring countries such as Romania. There is also reason to be more cautious on the outlook for Russia following its strong performance last year. Issues of corporate governance have again been raised by the arrest and imprisonment on tax charges of the chief executive officer of Yukos, one of the country's leading oil groups - a further cause for concern.
Elsewhere within the region, our belief the outlook for growth in information technology stocks is now largely priced in to many share valuations has led us to reduce investment in countries such as India and Israel, where IT stocks form a significant part of their markets. This decision comes after a period of considerable strength in the sector - companies such as Indian software group Satyam Computer have seen their shares rise strongly - in this instance, on the back of continued new order wins and a rise in sales to its largest customer, General Electric.
A cautious view on the prospects for South Africa is had, largely in response to the strength of the rand that is constraining the country's macro-economic growth outlook. It is expected investment in the country should be targeted at those sectors likely to benefit most from the currency's depreciation, which ought to occur having moved to an artificially high level. Miners such as Anglo American and Impala Platinum, two of South Africa's largest miners, are likely to benefit from rising commodity prices for some time to come - platinum, for instance, recently rose to a 24-year high. According to some analysts, low investment in the industry in the 1990s will lead to shortages and, as a result, commodity prices are expected to improve in real terms as the economic cycle progresses. This does not yet appear to be adequately reflected in miners' share prices.
To conclude, in terms of regions, there are positive prospects for Asia and Latin America, and in terms of sectors, there is a strong emphasis on resource stocks throughout the emerging market world. The outlook for the financial sector, especially banks, will continue to improve, as emerging economies' expansion broadens and deepens in response to the global economic recovery. Meanwhile, selected consumer cyclical sectors should benefit from the accompanying boost to domestic economies. A word of caution, although it is expected emerging market equities to continue along their upward path in 2004, the path is unlikely to be smooth and regular. Emerging markets remain vulnerable to poor newsflow, whether political, economic or stock-specific, and volatility is likely to remain a significant component of market performance. A robust and proven stock selection process is critical to achieve the high returns that investors in emerging markets are seeking, without taking on high risk.
In an environment of general economic growth, emerging market performance will be highly country specific.
Brazil and Mexico ffer some of the best investment opportunities in the asset class.
Paul Bruns and Elaine Parkes
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