Time to change your assumptions about emerging markets
A major shift is taking place in the attitude of investors toward emerging markets that we believe will continue to drive strong demand for emerging equities and eventually lead to a willingness to pay a premium for them over developed-market companies.
Role reversal
The global financial crisis has exposed fiscal mismanagement and left a legacy of unsustainable government debt. Policy risk and high unemployment are prevalent. The startling reality is that this is not a description of what is going on in emerging markets, but in the world’s major developed economies. Weakened and debt-laden US consumers appear to be ceding their status as the main drivers of global recovery to China.
Policy-makers in the emerging world appear to have had greater success in navigating through the credit crisis and its aftermath – they have kept growth alive and unemployment and inflation under control, contrary to previous fears. Meanwhile, many of their developed-world counterparts are fighting off the twin threats of a double-dip recession and deflation while struggling to reduce unusually high levels of unemployment.
Indeed, there are currently more developed- than emerging-market governments with a negative outlook on their credit ratings. The average price of credit default swaps, in effect an insurance policy against default, is now lower for China than it is for the average developed-market government. Merger and acquisition activity is also now greater in Asia than in Europe. Such radical changes in the mindset of investors and credit-rating agencies have not been seen before.
At the corporate level, emerging-market companies have made great strides in countering their reputation for having opaque accounting standards. Valuation measures such as price-to-earnings (PE) ratios are moving closer to developed-market averages. Indeed, ratios of price to book value (PB), or assets minus liabilities, are higher for emerging equities. However, this appears to be justified by much higher return on equity (ROE), a measure of the rate of return on shareholders’ interest in a company
In addition to superior return on equity, profit margins are also much higher than in the developed equity markets, while the volatility of earnings is no longer higher. Earnings per share for emerging equities have already recovered to close to pre-crisis levels, while this is not expected to happen in the developed markets until the end of 2012, according to consensus data. This recovery has encouraged companies to continue to invest, with capital expenditure continuing to grow in emerging markets during the credit crisis, strengthening the case for superior growth going forward.
Asian equities are the most expensive among emerging markets, based on PE ratios, but they still trade at a modest discount to US companies. Given the weaker growth of US companies, and all the baggage mentioned above, perceptions of risk and relative valuations need to be re-adjusted.
After a brief pause, the taps are back on
The global financial crisis caused a momentary withdrawal from emerging markets by investors, who worried these markets would be vulnerable to knock-on effects as they had been in previous crises. These fears largely proved unfounded, and after a short, sharp recession due to the collapse in global trade, emerging markets have bounced back. Investment flows have since recovered to well above pre-crisis levels. Furthermore, they have remained positive during the recent correction in the global markets, while money has been flowing out of developed-market equities. This highlights the shift in risk perceptions that is happening.
Emerging markets account for 14% of the total market capitalisation of the MSCI World Index. But according to fund surveys such as the Emerging Portfolio Fund Research global survey and US mutual fund data, most investors still hold less than this in their portfolios.
We expect positive flows into emerging markets to continue, driven by a seismic shift in investors’ perceptions and the increasingly important role of emerging economies in driving the global economy. We strongly favour emerging over developed equities, given both their superior economic growth outlook and scope for continued re-rating.
Disclaimer
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