The paradox of emerging markets.
The World Bank defines an emerging market as one where GDP per capita income is below $8,000 per annum. Thus, in an absolute sense, markets do not come much more emerging than in Africa. But healthy emerging markets, with the exception of South Africa, are generally regarded as being in South America and South East Asian countries. Africa remains the poor relation.
Emerging markets (EMs) account for 80% of the world's population and over 20% of global exports. Their combined share of global stock market capitalisation is between 6-10%. The asset class is quite diverse with more than 50 markets spreading across five continents.
Some fund managers, however, tend to regard EM equities as bad investments because of their volatility, and at times, poor returns. These markets are, in fact, poor hedges against other equities because of their strong correlations with the US stock markets, especially the tech-weighted Nasdaq.
Some observers have classified EMs as high-risk assets - similar to corporate junk bonds lacking investment-grade status.
During the past decade, Morgan Stanley Capital International's emerging markets index has risen only 5% per annum in US dollar terms. In January-May 2001, weekly returns on Merrill Lynch's Emerging Market fund were 90% more volatile than those on the UK All-Shares index.
Are EMs danger zones?
The ongoing weaknesses of the New York, London, and Tokyo financial markets are not helping the investment case for EMs. Most investors having suffered hefty losses this year and are cautious of diverting their portfolios to less developed markets where credit-risks are obviously much higher.
Currency crises, like in Asia (late 1997) or the Russian devaluation of August 1998, can also inflict heavy damage on EM investors. The recent report by Washington-based Institute of International Finance (IIF) said: "A sharp and disorderly adjustment in exchange rates with the potential to disrupt markets and inhibit capital flows remains possible."
An additional operational risk of investing in EM, be it India or Zimbabwe, is capital controls, i.e. restrictions upon repatriation of interest, profits and dividends, as well as principal (original capital).
Barclays Bank comments: "Zimbabwe is the classic case of an EM going from delivering excellent performance over a short period of time to one where investors experience extreme problems in getting both sale proceeds and income out of the country due to dire shortage of hard currency.
There are very few global multinationals in the EM universe, their activities extending to automobiles, pharmaceutical, telecommunications and information technology sectors.
Most EMs' leading companies specialise in cyclical businesses, such as resources (mining, oil & gas), household goods, construction/building materials and textiles. The performance of a cyclical stock is mainly driven by general economic conditions.
Analysts at Old Mutual Asset Managers argue that the cyclical nature of trading makes it difficult to generate adequate and consistent returns on investments.
Furthermore, interest rates are generally higher in EMs, (compared to developed markets), coupled with inefficient cost control mechanisms in some companies, often lead to lower returns on capital.
Despite the risks, some economists present the case for buying into selective EM funds, because of the under-valuation of most markets. Salomon Smith Barney, US investment house, estimates that average price-earnings ratio on EMs is below 13, compared to the US market's 23.5.
The London-based Economist Intelligence Unit (EIU) concludes that over the past year, EMs have become less risky places to invest. "Favourable commodity prices, better risk management and a stable (albeit slowing) global economy, provide the basis for better times ahead," say EIU.
EM fundamentals improving
Economic fundamentals of most EMs are improving, although at a slower pace compared with 1999 and 2000. Many countries, including South Africa, China, Brazil and Slovenia, are recording healthy fiscal and trade balances, as well as buoyant non-inflationary growth. The World Bank estimates this year's average growth rates in developing countries at 4.2%, down from 5.4% in 2000.
EMs are widely expected to be a major beneficiary of US growth revival, anticipated in the second half of this year, or early 2002. They gained a staggering 63% in 1999, when US stock markets surged. However, prime EMs could in fact benefit from US economic woes. This is because lower US interest rates may inject some liquidity into EMs as the more risk-averse investors reallocate their portfolios from US money market funds to other parts of the world.
The recent slow-down in earnings growth of US blue-chips could serve as a catalyst for funds outflows. Sophisticated institutional investors might take advantage of cheaper borrowing in dollars, and re-invest the funds into higher-yielding EMs' fixed-income securities. In June, the yields on benchmark South African government bonds were averaging 11.5%, compared to 5% on US Treasuries.
EMs will provide higher returns
The consensus among investment banks is that EMs should provide higher nominal returns this year and next, relative to developed (OECD) markers. Standards of corporate governance in places like South Africa and India are arguably better than some countries in the European Union like Italy and Greece.
East Asian companies are benefiting from industrial restructuring implemented after the financial turmoil of 1997-98, while companies such as AngloAmerican and South African Breweries, have improved their respective profiles by gaining access to international capital markets.
However, most investors are still somewhat wary of putting their money in EMs. According to the (IIF), net private capital inflows to 29 prominent EMs are projected at $140bn, down from $168bn in 2000 and $269.4bn in 1997.
Mohamed El-Erian, former Executive Director of the International Monetary Fund, advises that investors should focus on investments in "higher-quality countries, i.e. with solid macroeconomic policies, a stable political situation, sufficient foreign exchange reserves to withstand an external shock, and a good debt profile."
In the first half, the best performing EMs (measured by annualised earnings yield) were China, Russia, South Korea, Thailand, South Africa and Taiwan; whilst the six worst performers were Turkey, Israel, Czech Republic, Malaysia, Hungary, and Pakistan.
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|Date:||Jul 1, 2001|
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