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Investment
Quarterly - Q4 06:
Emerging markets |
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| Emerging
markets can offer spectacular growth performance, but the
risk attached to heavy allocation might be too much to bear.
Iain Morse looks at the drivers affecting emerging market
economies, and asks if there is still good potential for investment |
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Is
it too late to invest in emerging markets? Five years ago
they offered a cheap ticket to profit. Emerging market equities
and bonds traded at a big discount to those in developed markets
like the UK and US. When these more liquid markets fall, as
they did in 2000, emerging markets fall further and have further
to recover.
Over this five year period, the MSCI World Index has increased
by 50.86%, while the MSCI Emerging Markets ex-Asia index has
shot up no less than 247.78%. Emerging markets in Asia have
increased by 163.38% for the same period, and India by no
less than 338.47%.
These are head turning levels of return. Never mind risk,
institutional and private investors have thrown money into
emerging markets buying just about anything and everything
visible from dodgy banks to ill-managed infrastructure projects
to bonds issued by unstable governments. There is quality
in emerging markets, of course, but there is also a lot of
rubbish. “The question is whether and how far investors
realise how much risk they are buying in these portfolios,”
says Richard Batty, equity strategist at Standard Life Investments.
Separating the wheat from the chaff has been rendered more
difficult by global liquidity, the tide of cheap money unleashed
by American, Japanese and other central banks to create demand
in the world economy after 2000. This cheap money was used
in the ‘carry trade’; a cross-border and cross-currency
quest for higher yield. As developed economies reduced their
interest rates, the relatively high rates, in countries like
Brazil, suddenly looked very attractive; so Dollars, Pounds,
and Yen travelled to these countries looking for a temporary,
high yielding home.
Meanwhile, countries like China and India have hugely increased
their exports to developed economies. Buying trainers or DVD
players made in China, we are effectively exporting Pounds
to China; but what happens to these growing local surpluses?
“Many of these countries running trade surpluses are
re-exporting this money, buying US Treasuries and UK gilts,
real estate and shares,” adds Batty.
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Meanwhile, commodity prices have also had a major effect on
share prices in some emerging markets. The key metric here
is the amount of earnings from listed equities in each market
attributable to commodities, particularly oil and gas. In
the Russian Federation, around 80% of all earnings are derived
from oil and gas. In China the same figure is 70%, in Brazil
61%, Poland 59% and in the whole emerging market universe
an average of 45%.
This may be surprising, but these earnings totals include
listed companies which have effective monopolies on one or
more parts of oil and gas distribution in their respective
countries. Examples include PetroChina Ltd, rated as the world’s
55th largest company by Forbes Magazine, with an effective
monopoly in China supported by the government.
The effect of other commodity values on countries like Kazakhstan
also deserves mention. Many mining and extraction companies
domiciled in these countries, particularly the Russian Federation
and central Asia, have listed on the London Stock Exchange
as a result of booming commodity values.
But the value of copper and oil has been falling in recent
months after reaching record highs earlier this year. “And
the price put on commodities has partly been a consequence
of cheap money,” cautions Batty. One rarely noticed
consequence of booming oil, gas and other commodity prices
has been to hugely boost the tax revenues in these countries.
In some cases, like the Russian Federation, long-term foreign
borrowing by these governments has been repaid partly or wholly
to foreign lenders among the developed countries.
Another equally important effect of cheap money and globalisation
has been to strengthen many emerging currencies. This has
been an inevitable outcome of the economic trends already
detailed.
The case for emerging markets has looked compelling for several
years, but over the same period any risk premium for holding
these equities and bonds has been squeezed paper thin. If
anything disturbs the economic trends supporting such high
valuations then they will fall – the question is by
how far. This is a reason to be cautious about emerging markets.
But there is another argument against dedicated investment
into these funds.
With more and more global equity funds offering to stock-pick
the best shares in both emerging and developed economies,
there is little reason to opt for a purely emerging markets
fund.
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