The attraction to emerging markets

Emerging market equities have increasingly become significant alternatives for the international investor. Investors are being drawn to an arena that on the one hand appears to be attractive for investment because it offers potentially higher returns, but also proves challenging by exposing them to different risks and opportunities. 

More than 20 years ago, investors were introduced to an alternative equity investment opportunity to leading developed markets such as the US, UK and Japan.

In 1987, the concept of an ‘emerging market’ was new and had limited investment opportunities. The situation has since changed dramatically.

Emerging market equities have increasingly become significant alternatives for the international investor. Investors are being drawn to an arena, which on the one hand appears to be attractive for investment because it offers potentially higher returns, but on the other proves challenging by exposing them to different risks and opportunities.

However, as the search for above average returns continues, there has been a significant increase in the amount of funds being channelled into this emerging market asset class.

Since 1995, portfolio inflows into emerging markets have totalled more than US$123 billion. A significant amount, considering it includes the US$49 billion in net outflows in 2008 as a result of the global financial crisis.

The recovery in emerging markets and hunt for attractive investment opportunities, however, saw these funds return just as quickly, with inflows totalling more than US$44 billion in the first seven months of 2009, nearly 90 per cent of the outflows registered last year.

Emerging markets offer a number of important advantages and there are very good reasons why investors should adopt a positive long-term view of emerging markets.

Most importantly, while global growth has slowed, emerging markets are still expected to grow at a much faster rate than developed markets. In 2010, emerging markets are forecast to grow at an average rate of 4 per cent, compared to no growth in developed markets.

Although the slowdown in the global economy has had an impact on emerging markets, emerging economies are becoming more domestically driven. Government expenditure in areas such as infrastructure as well as private domestic consumption will, at least partially, offset the decline in growth resulting from slowing exports.

The services sector has also been gaining in importance, especially in China and India.

Another important factor contributing to the growth in emerging markets is the emerging market consumer. We have been stressing the importance of emerging market consumers since there are more of them: over one billion each in China and India, for example.

Emerging markets account for more than 80 per cent of the world’s population. With economic growth accelerating and population growth decelerating, per capita income is one the rise. In our view, markets such as China, India and Brazil stand at the front of the class.

Looking at the stability and safety of emerging markets, it is important to note the accumulation of foreign exchange reserves, which puts emerging economies in a much stronger position to weather external shocks than say 10 years ago.

Foreign reserves, for example, in China are the largest in the world, totalling more than US$2 trillion.

As of the end of April 2009, total foreign reserves in all emerging markets totalled US$4 trillion, while developed markets reserves stood at only US$2.5 trillion.

This is in marked contrast to 10 years ago, when developed markets had US$1,100 billion, almost double the reserves of emerging markets, which were US$668 billion.

Most important for value investors, the current valuations of emerging markets remain more attractive than developed markets.

As of the end of August 2009, the benchmark MSCI Emerging Markets index had a price-to-earnings ratio (P/E) of 16 times, cheaper than the MSCI World index, which was trading at a P/E of 21 times. Markets such as Russia and Hungary are down to single-digit P/Es, making them especially appealing.

In addition to emerging markets, we think frontier markets are looking interesting and could become tomorrow’s emerging markets.

We have opened offices in Vietnam and Dubai in the last few years to allow us to capture the exciting opportunities in the Middle East and Mekong River regions.

Additionally, the frontier markets of Slovenia, Romania, Croatia, Kazakhstan and Ukraine are also beginning to look interesting.

While the global economic crisis did interrupt some of the emerging markets’ growth momentum, we expect the long-term growth of emerging markets to continue.

Although we are optimistic about the markets’ upside potential, it is important to realise that volatility is still with us and will be with us for a while.

From an historical point of view, current valuations remain below their peak and are not excessive. As such, we not only continue to find particularly good value in markets like China, Thailand, Brazil, Turkey and South Africa, but opportunities in emerging markets globally.

Mark Mobius is executive chairman at Templeton Asset Management.