Emerging markets are the growth opportunities of the future. By definition, they are riskier than th...
Emerging markets are the growth opportunities of the future. By definition, they are riskier than their developed counterparts but they also offer a greater potential return. Emerging countries account for most of the world"s population, land and natural resources. Emerging markets are defined by a broad set of characteristics such as:
&149; Low GDP per capita
&149; High growth in working age population (and a lower dependency ratio)
&149; Low use of capital and technology in production
&149; Relatively small stock markets.
By employing technology that is already prevalent in the developed world, and by improving both legal and physical infrastructure, emerging market economies are able to achieve growth rates significantly higher than the developed world. In 2003, the largest emerging market economy (China) was the sixth-largest in the world. It is estimated that by 2050, four of the world"s largest six economies will be emerging markets - Brazil, Russia, India and China (commonly referred to as BRIC).
After an exciting period of growth in the first half of the 1990s, many emerging markets ran into difficulties, the main casualties being:
&149; 1997: Thailand"s devaluation and its knock-on effects in Asia
&149; 1998: Russian debt crisis
&149; 1999: Brazilian devaluation
Since then, emerging markets have undertaken significant reform to address the structural weaknesses revealed - for example, through improving legal structures and corporate de-leveraging. We are now beginning to see the benefits of these measures. These improvements, combined with a number of longer-term positives, provide a great investment opportunity. These factors are:
&149; Accelerating domestic growth. Positive demographic trends (that is, a rapidly growing young population) are leading to growth in domestic consumption, reducing emerging markets" dependence on exports to the developed world and providing an additional growth driver.
&149; A reflationary environment. Low global interest rates, a steadily depreciating dollar and flexible exchange rates are providing Asia"s governments with the opportunity to reflate their economies.
&149; Stronger commodity prices. Emerging markets account for 63% of the world"s natural resources and are benefiting from the current strength in prices, a trend expected to continue against the backdrop of a stronger global economy. The weakness of the dollar has helped to offset price increases for the net importers of oil (many Asian countries) and this trend is expected to continue for the foreseeable future.
&149; Resurgent Foreign Direct Investment (FDI). Firstly, the effect on emerging markets" capital accounts is clearly positive. Secondly, FDI accelerates the transfer of managerial and technological expertise into these emerging economies. Foreign investors demand better corporate governance and heightened focus on shareholder value, all of which will continue to push these countries in the right direction.
&149; Corporate deleveraging. Unlike developed markets such as the US and UK, companies in emerging markets have been reducing debt over the past few years. This, coupled with structurally lower interest rates, has reduced the cost of financing and is leading to higher profits and a higher return on equity (RoE).
&149; Increased focus on shareholder returns and improved corporate governance leading to higher RoEs.
&149; Rising tolerance for risk. In tandem with a decreasing level of market volatility, there is a declining risk aversion in emerging markets, reflected in the shrinking risk premium awarded to emerging markets" debt. Investors are entering emerging markets with a steadfast mindset, not shying away from the comparative risks involved.
Finally, there is the support expected from developed economies. The outlook for the US is increasingly positive, particularly in the first half of the year, and interest rates are expected to remain low. With domestic consumption playing an increasingly important role in emerging economies, US demand will enhance markets already primed for growth.
Fortunately, valuations do not yet reflect the higher growth prospects inherent in the emerging asset class. Since 2000, emerging and developed P/Es have been diverging; the former is now at a 35% discount to the latter. Emerging markets are trading on 11x prospective earnings, compared to 17x for developed markets. This discount remains, despite nearly 21/2 years of outperformance by emerging markets and the 55% (dollar terms) rise in value in 2003. Although a discount to developed markets is warranted by their higher risk characteristics, 35% seems excessive and there is scope to narrow. Improving RoEs in emerging markets have been ignored, as has dividend growth.
We are witnessing an impressive confluence of factors that should continue to drive returns in the emerging markets. These, coupled with attractive valuations, leave us optimistic that emerging markets will continue to outperform the developed world over the coming months and years.
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