Against all the odds, emerging mar-ket equities outperformed most other asset classes last year, pro...
Against all the odds, emerging mar-ket equities outperformed most other asset classes last year, producing very strong returns despite the tradi-tionally negative backdrop of rising US interest rates and a slowdown in US economic growth.
The MSCI Emerging Markets index is up more than 23% in local currency terms to 1 December 2006, compared to a 12% return for the MSCI World index.
A major reason for this strength has been the fact that economic indi-cators have remained strong, with robust third-quarter GDP growth now coming through from major markets in all emerging regions.
For example, Indian GDP growth accelerated to 9.2% during the last quarter and Chinese growth hit an exceptional 10.2% pace, while Poland stood at 5.8% and South Africa at 4.7%. Even in Brazil, which has been suffering from sluggish growth, the economy grew 3.2% last quarter (up from just 1.2% in quarter two).
Such strong economic growth is helping support corporate profits growth expectations, while glo-bal demand for emerging markets exports has continued to provide a significant boost to earnings. Furthermore, emerging markets val-uations are not stretched on a price-to-earnings basis and company bal-ance sheets are in sound condition thanks to strong exports. Also, with the exception of Turkey, Hungary and South Africa, emerging nations' finances remain generally sound.
Finally, since August emerging markets investors have been increas-ingly optimistic that we have seen the last US interest rate hike in the cur-rent cycle and that the US economy, which is responsible for soaking up such a large proportion of emerg-ing markets goods and services, is headed for a soft landing. The peak in US rates and the subsequent fall in US Treasury yields has been very supportive because in the past such a scenario has had a positive correla-tion with emerging markets equities.
These factors, along with the prospect of US interest rate cuts in the first half of next year, should continue to support the emerging markets asset class.
However, investors should note that the potential for volatility within global emerging markets still exists. We have already seen a wave of country-specific events in recent months causing some volatility in individual markets, including a coup in Thailand, political riots in Hun-gary and political scandals in Brazil prior to the presidential election.
At the same time, the lack of breadth in the rally since early August also argues for some cau-tion, especially as emerging markets are continuing to absorb the full implications of tighter global mon-etary policy, ebbing liquidity and the slowdown in US economic growth. With risk appetite still at a relatively low ebb, emerging markets do look vulnerable to further weakness if the US economic outlook turns sour.
In terms of individual regions, the Eastern European market performed very well last year, but may be vul-nerable to political instability related to elections across the region over the next 12 months. The more commod-ity driven markets, including Russia, will also be affected if oil and metal prices remain under pressure.
In Asia, falling oil prices and an economic soft-landing scenario in the US would be a favourable combi-nation for regional equities. However, given these uncertainties, domestic demand-oriented markets at reason-able valuations are favoured.
Value still exists in Latin Ameri-can markets, notably Brazil, where it is encouraging to see the re-election of Lula da Silva will mean a continu-ation of his largely market-friendly reforms. In Mexico, the election vic-tory of Felipe Calderón bodes well for economic reform.
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