Bric and beyond

The Credit Crunch

Attractive as emerging market returns have been, it remains the case that a solid track record neither predicts nor guarantees future performance, and this rubric is particularly relevant now because the full consequences of the sub-prime debt crisis within the investment and retail banking sectors have yet to be revealed, and in the worst-case scenario threaten a global credit squeeze, and a deep recession in the US and probably beyond. So, a burning issue for all current and potential emerging market investors is the degree to which individual developing economies are likely to be affected.

As any investment primer will tell you, the key justifications for investing in the emerging markets are not only exposure to faster-growing economies but also portfolio diversification. The diversification benefits arise from the low correlation between the volatility of these markets and that of established markets in North America, Europe and Australia, which are all joined at the hip. Japan used to be a member of the club, but a preoccupation with persistent domestic deflation over the past decade has caused the Nikkei to move independently.

The low correlation in volatility between the emerging markets and the developed markets is easily explicable: the 26 countries that make up the emerging market investment space are highly disparate. Indeed, the only characteristic they have in common is their potential for economic growth, and each has a specific risk profile in terms of political stability, macroeconomic and central bank competence, the depth of market liquidity, accounting standards, securities regulation, the endowment of natural resources, regional trading links, labour market skills and so on. However, it’s a moot point whether the economic growth generated by inward emerging market investment over the past decade has made them more rather than less dependent on the behaviour of the US economy, and indeed that of the rest of the industrialised world where consumption over the past decade has been financed by cheap credit. So, investor attention should now focus on those developing economies that have acquired the political, institutional and financial muscle to sustain economic growth. Here we are talking about their capacity not only to exploit both fiscal and monetary policies to expand domestic consumption, but also to cultivate new intra-emerging market trading relationships.

Over the longer term it’s highly likely that the pre-eminence of the US will be eclipsed by a mightier economy. Both China and India are in the frame to overtake the US in total gross domestic product (GDP) terms, but this is only credible if they continue to grow GDP at current rates (10 per cent and 8 per cent, respectively) over the next three decades. However, pundit predictions are invariably based on crude extrapolations that assume the existing political and economic conditions supporting growth in both China and India are sustainable from here on.

Consumer demand is certainly growing strongly within the so-called 'Bric' economies of Brazil, Russia, India and China, but in terms of magnitude, it’s relatively small compared with that of the US and EU, despite the enormous size of Asian and Latin American populations. GDP per capita is the usual indicator of consumer demand (although that’s flawed because it takes no account of either population size or the distribution of wealth), and overall income per head in the most vibrant and populous emerging markets is insufficient to take up the slack of a major contraction of consumption within the industrialised economies. Indeed, the people with the greatest per capita spending power are the oil-rich gulf states with tiny populations, but they are hardly in a position to consume on behalf of the US and Europe, although as sovereign fund states they are well-placed to provide capital for ailing US financial institutions – Citigroup, Merrill Lynch, Morgan Stanley.

In the light of this, it would be unrealistic to expect current levels of emerging market growth to be unaffected by a recession in North America and Europe. But, as any sophisticated investor will tell you, when there’s blood on the floor it’s often a good time to buy – provided that valuations are realistic. So far as the emerging markets are concerned this is not always the case. Developing economies offer the prospect of outstanding economic growth, but investors should be aware that the emerging markets are neither bargain basements nor safe havens.

Emerging market Optimism

Despite all the doom in the financial press, many emerging market specialists are optimistic because each developing economy has unique characteristics, and some are far better insulated than others to withstand the consequences of a full-blown US recession. In the jargon, they are deemed to be either 'coupled' or 'decoupled', with varying degrees in between.

Export dependence, particularly on US consumers, is the first thing that comes to mind, and here Singapore, Hong Kong and Malaysia are the most exposed with exports to the US equivalent to 20 per cent or more of their GDPs, compared with 8 per cent in China and just 2 per cent in India. But, as the optimists point out, EM prospects are not exclusively defined by export exposure, and even where an emerging market has not ‘decoupled’ from the US, this doesn’t necessarily mean that it would be dragged down.

"How come" you might ask? Surely, a serious contraction in foreign consumption would invariably squeeze profits, and historically periods of uncertainty have stifled EM growth. Typically, this was due not only to export dependence, but also government initiatives to staunch capital flight and support the currency. As a consequence both internally generated consumption and investment were either put on hold or wrecked.

Nonetheless, as Hugh Hunter, manager of WestLB Mellon Compass Global Emerging Markets fund, says: "The fundamentals are the best in a generation." Here, the argument runs as follows: where an emerging economy has healthy foreign exchange reserves, and both trade and fiscal budgets are in surplus, or close to balance, they should be able to cope because these conditions provide governments with the fiscal and monetary tools not only to control domestic inflation, but also to invest in infrastructure development. Needless to say, the careful management of real interest rates is vital to the development of local enterprise, while sensible investment in roads, railways, housing and education would foster internally generated consumption and investment.

The most favoured countries are the Bric markets because all four continue to build up vast foreign exchange reserves, and all have solid GDP growth rates. Inflation in China and India is of concern, but it appears to be under control, although rising food prices make this more difficult to manage.

How to Invest

Some exposure to the emerging markets within a portfolio is worth considering. Even though the impressive growth rates of the past decade are unlikely to be repeated over the next five years or so, there are good reasons to believe that many emerging markets are in a position to stand on their own two feet and grow GDP at a higher rate over the longer term than either the North American or European economies could possibly achieve.

Even so, given a background of global economic uncertainty, emerging market volatility will probably become even more frenzied than it is now. In light of this, private investors are best advised to invest via a diversified mutual fund.

You can choose from open-ended funds, investment trusts or exchange-traded funds. If you opt for a general emerging markets fund, make sure you understand how the investments are spread geographically. Investing in a single region or country is a higher-risk strategy so most investors should stick to generalist funds.

Meera Patel, of independent financial adviser Hargreaves Lansdown, favours Aberdeen Emerging Markets (managed by Devan Kaloo) and First State Global Emerging Markets Leaders (managed by Jonathan Asante). She points out that these funds focus on high-quality companies, rather than short-term momentum, making them ideal for long-term investors and lower risk than some of their rivals.

Overall, Ms Patel recommends having no more than 10-15 per cent of your portfolio exposed to emerging markets with a maximum of 5 per cent exposed to a single country. Meanwhile, Simon Elliott, of broker Winterflood Securities, likes investment trust JP Morgan Emerging Markets (managed by Austin Forey), which is currently trading on a 10 per cent discount, wider than the 9 per cent sector average.