August 2008

GLOBAL EQUITIES: Taking a world view

Emerging markets have become a main feature in global equity portfolios. Angele Spiteri Paris asks if recent falls will see a change ... Emerging markets have become a mainstay in global equity portfolios as cheap stocks provided easy access to these fast-developing regions. But with the MSCI Emerging Markets Index marking its first underperformance in five years and valuations looking less attractive – could the role of emerging markets in a global portfolio be under threat?

Five years ago, when the acronym BRIC was just starting to be thrown around, an allocation to emerging markets was an interesting addition to a global equity portfolio, but far from being essential.

The picture is very different now as the importance of global emerging markets (GEMs) has come to the fore and no manager can call himself a global manager without astute investment in this category.

A simple look at the MSCI All Country World Index is sufficient to reveal the increased weighting in emerging markets as compared to the broader global scope. In the last five years the emerging markets portion of the index has jumped from 3.98% in 2003 to 11.20% in 2008. This is a testament to the increasing importance the emerging markets have on the global environment.

Lucy Macdonald, CIO of global equities at RCM, says: “Emerging markets are definitely a part of the overall global equity landscape in a way that they weren’t five years ago. As a global equity investor you must have the expertise in those areas.”

A European Central Bank working paper expounding the relevance of emerging markets to global equity markets says: “Emerging markets can no longer be considered as a minor player in global financial markets that matter only in times of crisis or financial turbulence.”

According to the paper these economies are likely to become a vital factor in the determination of global asset prices going forward.

This sentiment is reflected in the way global equity managers have been behaving when it comes to emerging markets. On average one could say global managers moved from holding around 5% of their portfolio in emerging economies to roughly 15%, depending on their risk profile.

When first ‘discovered’, the case for emerging markets was straightforward – they provided cheap access to high returns and the asset class, as a whole, did not miss a beat for a number of years.

The sharp market correction, however, has seen the emerging regions singing a different tune as the MSCI Emerging Markets Index, a broad measure of equity performance in global emerging markets, fell 12.7% in the first half of 2008.

This therefore suggests that managers need to find other reasons for investing in these areas, rather than just cheap equity. Also, the rush to market within these countries has led to high valuations suggesting one needs to hunt around for value for money.

“By Q3 2007 valuations in selected emerging markets just exploded,” says Alexander Shalash, head of emerging markets team with Julius Baer, managing Black Sea, Northern Africa and Russia funds. “This played a dual role within global portfolios because as the stock prices went up, so did the average growth expectations,” he explains.

One of the reasons behind the valuation upsurge is that some of the ‘emerging’ economies are now becoming more similar to those of the developed world. The improved regulatory environment and greater transparency has led to more stable markets, but this also translates into reduced returns.

Some emerging equity markets suffered because there was not enough depth in the local market to keep up with the demand. Shalash cites Vietnam as an example.

“This was an extreme case. There has been an explosion on the index level in Vietnam, driven by the very low liquidity and almost every major bank issuing some form of Vietnam certificate or basket of equities,” he says.

Winners and losers
The underperformance of some emerging markets may have come as a cold shower for some – however it brought about a disentangling within the asset class showing that some economies could withstand shocks better than others.

Charles Burbeck, head of global equities at HSBC Global Asset Management, runs down the list of winners and losers in the emerging markets.

“China and India have been the clear losers of the BRIC countries with China being down by around 45% year to date and India being down by about 40%. Brazil is up by approximately 10% and Russia is broadly flat. These steep falls mean that valuations have fallen to more attractive levels, which in turn may present a buying opportunity for longer term investors,” he says.

Industry experts explain that this performance was largely due to the commodities boom and resource-rich Brazil and Russia making the most of it.  Both countries are large oil producers and although, like other emerging markets, they have inflationary issues, their natural resources help keep them afloat.

Julius Baer’s Shalash suggests the lack of broad-base retail investor participation in these two countries [Brazil and Russia] could have also contributed to them performing better than their counterparts.

“According to our sources in China, there was a significant amount of retail speculation in equity markets. The bottom line is that equity investments were over promoted without the risks associated with them being highlighted,” Shalash claims.

He said this also happened in India to a certain extent. In Brazil and Russia, however, most of the investment was taken out by global investment funds and therefore this phenomenon did not occur.

The disappearance of the valuation discount and the relative slowdown in the emerging economies therefore suggests that managers need to be more selective and sophisticated in their approach to emerging market equities, rather than making a sweep of attractive regions.

Market movements have led to some caution around this asset class with investors showing concern and making quite large redemptions. Although the resourced-based economies have held up quite well, many are concerned about whether this is sustainable.

Time to buy
On the managers’ side, however, the general attitude to the emerging markets is still very upbeat as they highlight several fundamental reasons why these areas add value to a global portfolio.

According to Ronald Frashure, president of Arcadian Asset Management, now is the right time to buy into emerging markets, in spite of the rife pessimism.

“During this difficult year, emerging equity markets have actually held their value more successfully
than developed markets, with declines of considerably smaller magnitude than those seen in the US, Europe and developed Asia,” Frashure says in a paper entitled Emerging Markets: Has their time finally come?

In fact, although the asset class as a whole did underperform, the margin was very slight and considering the strong performance witnessed in the past this was bound to happen at some point.

Therefore, there is no reason for the importance of these markets to be downplayed, especially when one considers that the greatest emerging market equity success stories would have been winning choices regardless of their domicile.

Macdonald of RCM says: “We want to be able to justify a company on its own merits, from a bottom-up point of view, not invest in it just because it happens to be in a particular market.”

Burbeck of HSBC Global Asset Management echoed this sentiment, saying: “There are some world-class companies in the emerging markets that were, and still are, an attractive story in their own right.”

He spoke of Samsung and Hyundai as being two perfect examples of companies that were interesting on the basis of their product offerings, thought-leadership and overall management, rather than because they were based in emerging Asia. ©  2008 funds europe

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