Hitting the wall

Contrast

So why the contrast? Let's take the short-term first. Interest in emerging markets was boosted in the wake of the financial crash as the US Federal Reserve and other central banks flooded the system with cheap money. Speculators duly obliged by diversifying away from more mature markets, partly to take advantage of the higher yields on offer, and also to profit from a steady decline in the value of the dollar.

However, all good speculative runs come to an end, so when the wind of economic change swung around to favour signs of economic recovery in the US, investors started to fret about the prospect of the Fed tightening monetary policy. As a result, US bond yields have risen because at some point the end of quantitative easing and the Fed's buy-in of bonds would be followed by a rise in official interest rates (see 'Fed watch').

This is all too true, although it's fair to say that market reaction is considerably ahead of the curve, so much so that the time-honoured and inevitable over-reaction will at some point provide buying opportunities in emerging market equities and bonds, when the current speculative outrush ends. And whatever the Fed does, the pace of economic growth in the US will remain slow and far behind emerging markets.

Investor wariness

To assess the longer-term outlook, and the immense potential growth still to be unlocked in emerging markets, you have to stand back and take in a broader view.

Over the years, emerging markets have accumulated a must-avoid reputation for some investors. And while it would be inappropriate to tar all emerging and frontier nations with the same brush, such caution is based on solid foundations, with history littered with tales of woe stretching from South American countries staggering into default, African countries run and ruined by dictators, and illiquid markets embraced by political despots, corruption and instability. But most of this took place a long time ago. It's easy to forget, for instance, that the Berlin Wall and the collapse of communism in eastern Europe took place nearly a quarter of a century ago. True, not everything is sweetness and light - events in Venezuela currently look unpleasant as hyperinflation threatens to take hold - but investors don't have to explore the depths of deepest South America to come unstuck. Try looking at Greece, Ireland, Portugal, Spain and Italy.

And attitudes have changed in many emerging economies because, unlike developed countries, where the population is wrapped in the cotton wool of a nanny state to mitigate the effects of a severe economic downturn, those safeguards are largely absent in less well developed countries. And where there is an element of democracy, politicians are quick to realise that retaining power goes hand in hand with maintaining the local economy on an even keel and keeping the voters happy. Former hot beds of instability have become less so as politicians adopt a more cautious stance coupled with sustainable economic policies.

However, it takes time to adjust to the post puppet environment, and legacy perceptions remain. But emerging markets are really not that much different to more sophisticated investment environments, in that making a decent return is inextricably linked to making the right investment choice. Tactical asset allocation remains as important in these markets as anywhere else.

Potential

So where is the potential for making a really attractive return? Taking this year as a starting point, GDP growth among emerging markets is expected to average around 6 per cent. That's a big difference to recession-hit Europe, the stagnant UK or even a recovering US. Even Germany has just had its GDP forecast output for this year cut in half to 0.3 per cent by the International Monetary Fund, and that’s before taking into account the effects of recent extensive flooding in some parts of Germany. Furthermore, total debt levels in emerging nations are around one-third of those in the developed world. That's a good start, but it's the growth potential that is the most exciting aspect.

Let's take a look at China as a starting point. The change from export-led growth to domestic-consumption-led growth will have a profound effect. For example, in the next 12 years there will be created an estimated 107 new small cities, 46 mid-sized cities, three large cities and six new mega cities. Put another way, this is the same as 100 new Birminghams, 46 new Berlins, three Londons and six Moscows. This is the equivalent of a population expansion significantly greater than the current population of the entire US. Car sales in China have already overtaken those in the US, and yet car ownership is still only one in five.

Breakdown

And for the first time ever, emerging markets this year will produce a majority of the world's goods and services. What's more, three-quarters of global economic growth over the next five years is expected to come from emerging markets. In fact, no country in Europe is expected to make the top 10 countries by share of global growth, with the whole of the EU expected to account for just 5.7 per cent of world growth in the next five years.

However, the link between economic growth and higher share prices sometimes strays. In fact, Mike Deverell, investment manager at Equilibrium Asset Management, suggests that those who cannot afford to tie their money up for the long term should look elsewhere. Yet, as Adrian Smith, managing director of financial adviser ASPL points out, investing in China 15 years ago would have delivered returns of up to 800 per cent. Looking ahead, he reckons that sub-Saharan Africa warrants attention, given the wealth of natural resources and the Chinese as willing investors.

Dividends are becoming an increasingly important component of returns for emerging market equity investors, accounting for 40 per cent of the total returns of the MSCI emerging markets index since 2000 (see Tap into emerging income).

What's more, in 2011 a larger proportion of emerging market companies in the MSCI countries paid a dividend than those in developed markets. Asian equity specialist group Matthews Asia also points out that between 1999 and 2012, 46 per cent of the total return of the MSCI China index was generated by dividends received and reinvested. And reliance on dividends has become more pronounced in recent years. In fact, from 2010 to 2012 the MSCI China index produced a total return of 6 per cent, but without reinvested dividends this would have been -3 per cent.

Justin Wells, strategist at UBS Global Asset Management, added that emerging market companies have cash on their balance sheets and have been consistently paying down debt over the past decade. Current net debt to equity ratios are below 24 per cent, around half the ratio in developed market companies.

Increased volatility

However, there is another side to the investment story, one that should encourage investors to adopt a more cautious approach, in the short term at least. Emerging markets are more vulnerable to, and volatile as a result of, political developments and economic news. Only recently the Turkish equity market suffered its worst one-day fall in a decade as a result of protests against the government, while South African mining stocks took a battering after more wild-cat strikes.

There are also question marks over China, not so much concerning the growth potential, but how effectively the authorities can switch from a heavy reliance on internal infrastructure investment and exports and rebalance more in favour of domestic consumption. And there are further concerns about the country's sprawling shadow banking system, which has funded as much as half of all internal investment. This a worry because unofficial estimates suggest that around one-third of all new savings by Chinese investors last year went into schemes run by various off-balance sheet, trust and non-banking organisations, with products typically of a three to six-month maturity period. But the residential housing projects that they are typically funding run for up to five years. And, as products mature, new deposits are used to pay back previous investors, which sounds ominously familiar. These concerns, raised by Jason Hollands of investment advisory group Bestinvest, highlight the potential fragility of the Chinese financial system unless the authorities move to constrain these sorts of practices. Ratings agency Fitch has warned of the systemic risks of what it describes as an "unprecedented" credit bubble.

Of course, in doing so, they would inevitably squeeze growth rates, suggesting a more sustainable GDP growth rate nearer 5 per cent to 10 per cent. And it’s worth noting that mining group BHP Billiton is basing its own internal forecasts on Chinese GDP growth at 6 per cent for 2014, a serious deceleration.

Indeed, commodities - China is by far the largest consumer - make up a significant part of overall growth in emerging economies, so a weak commodity market has pulled down the broader performance measures. And in a May survey by BofA Merrill Lynch Fund managers, a quarter of respondents mentioned a hard landing in China and a commodity collapse as the top risks - that's up from 18 per cent in April.

Furthermore, the proportion of global investors in the survey overweight in emerging market equities plummeted to a net 3 per cent from 34 per cent as recently as March, while those underweight in bonds came down from a net 50 per cent in April to 38 per cent. But, since then, bonds have taken a pummelling on the idea that US interest rates are more likely to rise, and most mutual funds investing in bonds in May lost money. Basically, it seems that investor sentiment is doing little better than lurching from one set of economic data to the next nuance or innuendo extended by central bankers who are themselves constrained - in the case of Europe and the US - by a lack of political will to tackle what will inevitably be a painful and long path before returning to economic prosperity.

However, emerging markets cannot shield themselves from the trials of their more industrialised cousins. In May, for example, industrial production figures in Mexico posted their worst performance since the financial crisis, sliding 4.9 per cent from a year earlier and far more than a forecast 1.4 per cent decline. But take out factors like fewer working days and weak mining and utility sectors, and there were clear signs of growth, notably in the construction sector. The point here is that the non-performing commodities sector is distorting the broader picture, so it would be unwise to assume that headline indicators are a reasonable reflection of underlying trends.

Underperformance

Even so, the performance in recent years of emerging markets against the more industrialised world is clear, with emerging markets underperforming in the past year – much of which reflects a fall in commodity prices. This means that rotation attempts to unload the best-performing sectors to invest in lagging sectors simply hasn't worked. But there are still investment opportunities in the short term, notably in companies operating in the domestic growth sector. It's also worth taking a look from the currency angle. The logical progression - principally in the US - is for overworked printing presses to push so much money into circulation that the inevitable result is inflation. This, in turn, will lead to currency weakness as overseas investors withdraw assets, thus adding an upside exchange rate attraction to investments made outside the US. True, US interest rates will rise but not at the same price as inflation.

The key is to adopt a selective approach, because although the MSCI index has underperformed, within that index there have been some sparkling performers including the Philippines - the best performing equity market so far this year with a gain of more than 20 per cent - while Indonesia and Thailand are both ahead by almost 10 per cent even after the recent shakeout. So, passive strategies are not suitable because country selection is the biggest performance driver. It's also easy to be put off by short-term developments.

Brazil, for example, is fighting to keep its currency from falling any further as nervous investors become more risk averse on the possibility of the US Fed cutting of, or at least tapering, the monthly injection of credit into the banking system. These scares come and go, and even though a return to less pampered markets is inevitable, this does little to affect the longer-term prospect of slow growth in the developed countries.

On an output per capita basis, emerging economies have a lot of catching up to do. True, as with all adolescents there will be growing pains, but the potential long-term sustained growth rate is something that major developed countries will never achieve again. Some sectors, for example specialised financial services such as non-life insurance will probably remain the preserve of centres like London, but for raw growth the argument for investing long term in emerging markets is a compelling one.

MSCI Emerging Markets 1988