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Has the time come for emerging markets?

Written by Mathew Little
Feb/March 2015

Over the past six years, the exposure of charity investors to emerging market companies, in regions such as Asia, Latin America and Eastern Europe, has shown an unmistakable rise. According to investment analytics company State Street, in 2008 average charity asset allocation to emerging market equities stood at a mere 1.4%. But by the end of September 2014 it had grown to 6.5%. Yet since 2011, emerging markets have languished in distinctly ‘bear’ mode; they have underperformed developed markets by about 30%. Some investment experts believe that emerging markets have turned a corner. Others are convinced their underwhelming performance will persist.

On the surface, emerging markets’ stuttering performance is a puzzle. Emerging market economies have, after all, easily eclipsed their developed counterparts in terms of GDP growth. Staple emerging market countries China, India and Turkey grew by 7.7%, 5% and 4.1% respectively in 2013. This contrasts with 1.7% for the UK, 2.2% for the US and 0.1% in Germany. But the superiority does not automatically translate into impressive returns for emerging market companies. In fact, says Richard Maitland, head of charities at investment management firm Sarasin & Partners, “there is remarkably little correlation between short to medium term economic growth [in emerging markets], even up to seven to 10 years, and market performance.”

A major reason for this is that the companies generating or benefitting from emerging market growth are often based in the developed world. The most famous example is Apple, an American company whose profitability is immensely boosted by low cost production in China. Other western companies, such as Colgate, Pepsi or Burberry, may sell many products in emerging markets but are quoted in the UK or US. This can work in reverse, the South Korean technology company Samsung is an example, but this is less common.

“The problem for emerging markets is that as economies they have helped companies quoted in developed markets,” says James Bevan, chief investment officer with sector specialist fund manager, CCLA. “But emerging market quoted and locally operating companies face challenges associated with rising wages – less for shareholders – and credit bubbles.”

And emerging market investment means buying shares in companies quoted in emerging market stock exchanges.

“The notion that you can boost your returns by strategically allocating to emerging markets is, I think, comprehensively wrong,” says Maitland. “It’s what some investment managers advised their clients to do four or five years ago, and that’s one of the reasons why those investment managers have performed very poorly.”

Optimism

Nonetheless, charity investment in emerging markets has grown in the last decade or so, if only because many investment houses have broadened a traditional concentration on UK equities to take on an equal share of overseas equities, of which emerging market equities are obviously a part. Maitland, who rules out strategically holding a large quota of emerging market equities, still believes that “it would be peculiar not to include emerging markets in your thinking.” In fact, Maitland’s firm, Sarasin, the second biggest charity fund manager in the UK with £5 billion in charity funds under management, has in the last twelve months invested in more emerging market companies.

“For three years, emerging markets performed incredibly badly,” says Maitland. “Although emerging markets were in our benchmark and we could invest in them, until a year ago, we had very little – between 0 and 1.5% - because, tactically, we thought they were extremely expensive. But then they became very cheap and therefore tactically we have moved from a position of having 1% for our average client, to having 7 or 8% for our average client.”

Maitland is cautiously optimistic about how emerging markets will perform in the near future. “You have to be very careful because there are some very differently performing economies and stock markets,” he says. “But in the short term, we are overweight in emerging markets and we favour China, India, and Indonesia.”

Scepticism

However, this view is not universally shared. “In 2015, we believe that emerging markets equities will underperform global markets overall,” says CCLA’s Bevan. “This is a grouping that has tried on six occasions to break its post-2011 bear trend but without success.”

Although he agrees that “valuations are not necessarily expensive”. Bevan’s caution is centred on China, which in December officially became the world’s largest economy. He says that “the preconditions of a hard landing are in place.” China has the “third biggest credit bubble of all time”, he says, and a property bubble that rivals Spain and Ireland at their peak. “Chinese house prices have now fallen for six months in a row against a backdrop of falling housing turnover,” he says. He adds that, besides China, other emerging market countries such as the Philippines, Turkey, Brazil and South Africa, are at risk from high private sector debt. “That leaves only India apparently free of significant economic headwinds.”

Employment rates are also an issue. China, in common with other emerging market economies, has limited labour capacity, which means that there is pressure on wages to rise, which, though it is good for Chinese workers, means smaller dividend payments for shareholders. “Demographics is interesting because in countries like China the working population is just about to start declining, whereas India is going to have a huge boost to the working population,” says Jonathan Bell, chief investment officer of Stanhope Capital.

He believes economic growth in India could soon equal that of China. Bevan says all emerging market regions are marked by declining profit margins, in contrast to developed market companies, where there is profit growth. “One of the key reasons for this is that labour within emerging markets has been steadily gaining pricing power partly owing to high employment levels,” he says.

Oil

One element which will undoubtedly benefit some emerging market economies, China included, is falling oil prices. They have more than halved since last June (compared to rising 8% in 2013), swiftly becoming the dominant factor in determining how the global economy will perform. “The effect of the oil price coming down will be a material increase to world growth over the next year,” says Andy Pitt, head of charities in London with Rathbones, largely because consumers will spend more. But while emerging market countries that import oil will benefit, others, the producers of oil, will be hurt.

In terms of emerging markets, the biggest beneficiaries will be the Philippines, Turkey, Thailand, India, China and South Korea. Losers include Russia, Brazil and Mexico. Russia, one of the original Brics, faces the double whammy of falling oil prices and fallout from the Ukraine crisis. Investment there is already restricted by sanctions.

But the winners of the oil price tumble will outnumber the losers. “It would be our judgement that a falling oil price, when combined with the lower valuations that now exist after several years of underperformance [in emerging markets], will stimulate economic growth and, almost as importantly, investors interest in emerging markets,” says Maitland. The result will be rising share prices for emerging market companies, he believes.

But though investment managers tend to concentrate on emerging market equities, shares are not the only option. Government and corporate bonds are also possibilities. “Charities should consider the widest investment universe possible and find the things that are attractively priced,” says Maitland. He favours Indian bonds.

Bevan says: “Bonds [in emerging markets] have periodically done very well. “The current level of bond volatility is low and, in some cases, emerging market real bond yields are high. A case can be made for both Indian and Indonesian bonds.” There are funds available to charities that invest only in bonds and charities have the option of buying bonds denominated in emerging market currencies or dollars.

Emerging markets, much like developed economies, seem destined for divergence and uncertainty in the near future. There is no settled consensus as to what will happen. But there is agreement that charity investors should weigh up the pros and cons of investing in them. “Emerging markets should absolutely form part of your thinking,” Maitland says.

Mathew Little is a freelance journalist



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