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Supplements » EM Report 2011

MARKET ACCESS: You’re hired!

HiredThere are those who say many of us still lack enough exposure to emerging markets. As problems in the developed world persist, Nick Fitzpatrick asks fund managers why he should invest in their particular assets.

Sentiment about the short-term outlook for emerging market economies may have dipped recently, but these countries are still in relatively better shape than those of the developed world. Less debt and less pensions pressure are just two of the reasons.

Global emerging market (EM) equities are now a common feature of private and institutional investors’ portfolios. Meanwhile, the EM debt markets have become much broader and are now similar to those in the developed countries.

There are plenty of professionals to advocate investing in one of these asset classes, but there are also those who argue for direct currency exposure and for exposure through companies in developed markets whose emerging market earnings are important.

We take it as a given that none of the fund managers here advocates putting an entire allocation into just one asset class but, nevertheless, they talk about the virtues of the particular assets in which they invest.

Dilek Capanoglu, chief investment officer, global emerging markets, RCM
Quite a few companies in the Fortune 500 are emerging market companies, but for the active equity investor who can go off-benchmark to find the winners of tomorrow, there is still a huge universe out there that is being neglected. Emerging market equities benefit from currency appreciation, too, and we are positive about this. There are advantages for emerging market companies due to the fact that they sit in the emerging markets themselves rather than in developed markets. These advantages are seen in their cost structures, brand recognition, and in the proximity to their customers.

Emerging markets have underperformed developed markets over the last few weeks but they should come back in the second half of the year. Inflationary pressures, which were mainly driven by food prices, should ease off. India, for example, is expecting a good harvest.

Inflation in emerging markets should be seen in relation to the wage growth. An inflation of 8% to 10% is not as big a problem if we have 10% to 15% growth in wages.

If you compare the size of the population, their foreign exchange reserves and their exports with the size of their market capitalisation in a global context – which is 10% – there is a huge discrepancy between their strength and importance on the one hand, and capitalisation on the other.

Maarten-Jan Bakkum, senior emerging markets equity strategist, ING Investment Management
Emerging market equities are a great way to play emerging market growth. The growth differential between emerging market equities and developed market equities has narrowed over the last two years and I think it will stay low. There is now a 4% differential. A few years ago it was 7%. Inflationary pressure is building.

But emerging market equities are good in the longer term due to superior economic growth and demographic factors. There are big obstacles to growth in the developed market, such as the high dependency ratios of the ageing population, which puts pressure on fiscal accounts. However, the themes we have seen in emerging markets over the last ten years, such as liberalisation and reform, are losing strength. More countries are following China with aggressive economic policies, and corporations are concerned about trade imbalances and inflation. Currencies are key for returns as the dollar weakens. Equity returns together with currency returns push up market volatility.

Kevin Daly, portfolio manager, emerging market debt, Aberdeen Asset Management
Emerging market local currency debt has much lower volatility than equities so if you are worried about choppiness within financial markets then this asset class is a good fit for someone with a lower risk tolerance.

At an Aberdeen conference recently in Berlin, I was surprised to see that pension funds there all had emerging market equity exposure but nearly no emerging market debt exposure.

Returns on a risk-adjusted basis have outperformed emerging market equities since 2003 when emerging market local currency bond indices were introduced.

At year-end 2010 and since the end of 2003, annualised returns from local currency bonds were 13.64% versus 22% for emerging market equities. However, volatility was 11.5% for debt and 24.5% for equities. That means the underlying Sharpe ratio was 0.93 for bonds and 10.77 for equities.

Liquidity can be an issue but there are small cap emerging market equities with less liquidity than emerging market bonds.

I am generally talking about sovereigns but corporates are viable and will outperform hard currency emerging market sovereigns.

If you access emerging market growth through developed market equities then you are taking on developed world risk even though many multi-nationals get income from emerging markets. This is the chink in the armour of that approach.

Jerome Booth, head of research, Ashmore Investment Management
Deciding which is the best asset class to tap into in emerging markets depends on the usual criteria, such as portfolio composition and liabilities. I believe institutions should be in emerging markets across a wide range of asset classes to move their risk away from the developed world.

But if I were to select one to start with, it would be local currency debt. This is because investing in emerging markets today is to reduce risk, not just increase return, and the very largest risks today are firmly in the developed world. 

EM local currency debt is arguably the safest asset class in the world. The market is a money market, and the currencies are safe relative to developed currencies when one thinks of the biggest risks.

As it dawns on more people that the emperor has no clothes and the dollar is not safe, it is telling that after the Libya oil shock and after the Japanese tsunami, the dollar fell and local currency debt rallied. We have new types of investors starting to put money into emerging market debt to reduce risk and as an alternative to US Treasuries.

With local currency debt you also get the benefit of three different sources of alpha: credit, currency appreciation, and duration.

Within the broader fixed income sector I like this asset class because the ownership of local currency debt is more heterogeneous than for US Treasuries, which are largely owned by only two investor types – emerging central banks and the US Federal Reserve. Central banks could try to leave en masse, creating a liquidity crisis and dollar crash. 

Many emerging markets now have a large and growing domestic savings base. There are large pension funds in these markets, too, and local investors dominate. Thus, if I want to invest in Turkey, there is an instrument, whatever my view may be – I never have to leave the market.

Institutions are under a lot of sales pressure to buy equities, but their motives should not just be about getting the biggest bang for their buck, which equities traditionally give. These days it should also be about risk.

At the moment, the dollar is the riskiest significant currency globally, and as a macro economist, I’m also extremely worried about the Eurozone.

Sheila Hartnett-Devlin, client portfolio manager, American Century Investments
A lot of growth for developed market companies is coming from the emerging markets consumer who has more impact on developed market economies now. Emerging market consumption as a percentage of global private consumption in 1990 was 17%, while at the end of 2010 it was around 30%. Incremental demand from the emerging market consumer is why we did not have as deep a recession in the United States as we could have done.

You can see incremental growth coming through in the luxury goods, banking and infrastructure sectors. In some cases, there is greater liquidity in developed market companies and accounting and financial reporting is more transparent.

Using developed market companies to gain exposure to the emerging markets may provide some downside protection to the volatility of the emerging markets. In terms of risk, when there is a pull back in emerging markets, for example, you have that offset by the developed markets, which often do not have the same downside. This reduces the risk associated with high-growth economies.

The main themes are infrastructure in China and Brazil, luxury goods and technology. Some of the companies we like include Danone; 43% of its revenues are from global emerging markets, and 10% from Asia ex-Japan. In its bottled water business, all incremental growth is from emerging markets, particularly Latin America. Danone has also been able to pass input-cost pressure along.

BMW saw tremendous demand coming from China in 2010. Unit sales in that country in the last 3Qs of 2010 grew by more than 90% and China accounted for 14% of unit sales as of 3Q 2010.

Apple is still attractive to us. The penetration of the iPhone and the iPad in emerging markets is good. A lot of people are upgrading their mobile phones as they gain wealth. We think people underestimate the potential growth of iPads. It will go beyond the occasional user and extend to corporates.

Jean Medecin, senior product specialist, European equities, BNP Paribas Asset Management
If you access emerging markets through EM equities then diversification is limited. For example, about 60% of the China index is financials, and two-thirds of the market cap of Brazil and Russia consists of basic materials, financials, oil and gas.

In China, the dominant investment themes are the consumer and infrastructure. Luxury goods and car sales are booming, with companies such as Louis Vuitton, Swatch, BMW and VW benefiting. For China’s infrastructure, a great chunk of equipment to support this development is from European suppliers such as Atlas Copco, and Rio Tinto, which provides iron ore used by the steel industry.

If you want to be truly exposed to emerging markets then you have to rely on some European companies. I favour European companies over US companies because a lot of European companies have been historically constrained in their home markets and were, therefore, more aggressive at establishing themselves in emerging markets.

For example, the two largest advertising agencies in China are British (WPP) and French (Publicis). This is because they have to find growth outside their home markets because they cannot find it domestically.

It is true that you are exposed to European risk, but for certain companies the European exposure is marginal. There are certain sectors where emerging markets are 65% of the total sum of parts, such as suppliers of equipment and services to the energy sector, and metals and gas. Quite a lot have limited exposure to Europe.

There are also many emerging market companies that are themselves exposed to Europe. You have to remember that you will not always find emerging market companies that are purely domestic. Some have joint ventures with Western companies, some have European subsidiaries such as Jaguar for Tata Motors or Volvo for Geely, so it is not just European companies that have exposure to Europe.

Also, top-line growth and bottom-line growth are not always correlated. A recent London School of Economics study has shown there is very little correlation between gross domestic product (GDP) growth and equity performance. Just because your GDP is growing slowly does not mean a company cannot deliver good growth. Margin expansion and international exposure are two factors in particular that can justify good earnings growth in a sluggish domestic GDP growth environment.

James Wood-Collins, CEO, Record Currency Management
The currency component contributes to the total return from emerging market equities and bonds. Over a period of time, between one-third and one-half of the return is typically from the currency component and not the assets themselves.

We would encourage people to think about both sources of return – underlying assets and currencies.

Access to currencies through bonds is limited and will be driven by indices and issuance – a debt investor will be driven to the currencies of countries that have issued the most debt. For equities, if you invest in the MSCI Emerging Markets index, about 60% of that covers just four currencies – China, Taiwan, Brazil and Korea.

Neither debt nor equity portfolios will have been constructed from a currency perspective.

Although holding local currency emerging market debt benefits you with the currency effect, your currency position is long on the emerging market currency and effectively short on the one currency you sold to buy the bonds. Your return is, therefore, as dependent on the performance of that one short currency, as is on the portfolio of long currencies, and thus undiversified on the short side.

We gain exposure through currency forwards, but for some currencies with exchange controls and where conventional forwards cannot be used, we will use non-deliverable forwards.

The key characteristic of emerging markets is that they are playing catch-up with the developed world. The relevant metric is GDP per capita, which is closing the gap with developed markets.

An economic consequence of this is that price levels in emerging markets are expected to rise to converge with developed market prices, and currencies will appreciate as this happens.

You can question whether companies listed in emerging markets are the best way to gain exposure to emerging market growth. There has been research that shows a negative correlation between emerging market growth and emerging market equity returns. It is not automatically the case that equities give you exposure to the market where they are listed. Currencies are a more pure exploitation of the theme of convergence of GDP per capita.

In a local currency debt portfolio, most bonds will be sovereign. The bonds will benefit from an increase in the currency spot rate, and from the yield pick up, that is, higher rates leading to higher coupons. However, both of these benefits are also features of currency return. Currency can, therefore, be thought of as effectively short duration local currency debt.

Bonds also benefit from the duration pick up. Currencies do not, but duration is the smallest portion of the bond return.

In terms of counterparty risk, we are not holding money in emerging market banks. Your cash stays in the UK or US. If one country introduces exchange controls, we negotiate the new value of the contract for that currency with the banks. This means that part of the fund value relating to the mark-to-market becomes subject to negotiation, but the fund principal is not touched.

©2011 funds europe