Emerging market exposure is healthy for your portfolio
Many emerging economies are now enjoying greater economic importance and increasing wealth than before.
In many cases, companies based in emerging market countries are benefiting from an increase in domestic demand, which is the result of the increasing size of the economies, lower interest rates and more widely available credit.
These factors may have prompted you to consider increasing your investment exposure to this sector of the world’s equity markets.
Michael Dodd, an investment analyst at financial investment company acsis, and Andrew Salmon, the executive head of investments at acsis, say emerging markets are typically associated with high growth levels and rapid industrialisation, and an emerging market usually has lots of potential consumers, lots of land mass with good potential for agricultural activity, and the potential for high economic growth.
“As much as 80 percent of the world’s population of six billion people are in emerging markets,” Salmon says.
The Morgan Stanley Capital International (MSCI) Emerging Markets index measures the equity performance of emerging markets. Each country’s weighting in the index is based on the market capitalisation (total value) of the shares in its stock market (in US$).
Currently, the following countries are represented in the MSCI Emerging Markets index: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, South Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.
Dodd says one of the biggest arguments for investing in emerging markets is their high potential for growth. Currently, emerging markets account for 37 percent of the world’s gross domestic product (GDP). This is forecast to increase to 49 percent of world GDP by 2020 and 59 percent by 2030.
According to the International Monetary Fund (IMF) forecasts in the recent World Economic Outlook, emerging economies’ growth for 2011 is forecast at 6.5 percent versus 4.4 percent forecast for global growth and 2.4 percent for developed economies.
“Both sovereign and consumer debt levels are lower for emerging markets than they are for developed market countries. Demographically, there is a favourable case for emerging markets with a growing population and middle class. Basically, emerging markets are becoming too big to ignore,” Dodd says.
Analysts say the increase in the debt level of developed countries has been rapid since the 2008 credit crisis and in the United States, for example, the ratio of debt to GDP is now 100 percent.
Developed economies such as the US and European countries may take years both to recover from the credit crisis and to repay their massive debts, which makes investment in the developed world less attractive.
On the other hand, government debt levels relative to GDP have been declining in emerging economies and are now less than 40 percent, which means it is easier for emerging economies to spend money on fixed investments because their debt levels are low.
On average, government debt in sub-Saharan African countries has fallen from over 70 percent of GDP in 2000 to just over 30 percent last year.
Since July 2010 to date, with the exception of a brief period around March this year, emerging markets have been outperforming developed markets (see the graph, “Equity market performance: emerging markets vs developed markets”).
While the MSCI World index returned 2.32 percent a year for the five years to April 2011, the MSCI Emerging Markets index returned 9.85 percent a year for the same period.
Analysts say although emerging markets may be overpriced relative to developed markets, they are expected to grow faster and as such will attract cash flows, which means that their equity markets should deliver reasonable growth.
How to invest in emerging markets
There are many ways for you to get exposure to emerging markets, such as through active or passive investment, direct investment in emerging markets or indirectly through listed companies on other markets.
Michael Dodd from acsis says emerging markets have different characteristics – for example, South Africa and Brazil are resource-heavy economies, South Korea is technology-heavy and China is heavy in manufacturing.
“There are both active and passive investment solutions available but given that emerging markets are less efficient than developed markets and that the benchmark MSCI Emerging Markets index has many restrictions that exclude a lot of potential stocks from the index, there is a strong case for active management in emerging market equities,” he says.
If you choose an actively managed fund, you can either invest in a fund focused on emerging markets in general or one focused on a specific market. You can also get emerging markets exposure by investing in a fund exposed to companies that are listed on developed market exchanges but that generate a large part of their earnings from emerging markets.
For example, the Coca Cola company is listed on the New York Stock Exchange but has been aggressively expanding its operations in emerging markets. In its most recently reported quarterly earnings, the company showed that it had experienced high-volume growth in Russia, Turkey and India. In April, Coke announced it would invest US$121 million in a manufacturing plant in India.
Similarly, American brewer Anheuser Busch, which is also listed on the New York Stock Exchange, recently launched operations in Russia and has plans to launch operations in Brazil in 2012. Emerging markets currently account for half of Anheuser Busch’s earnings.
You don’t have to invest only in equities as it is also possible to invest in a balanced fund with some emerging markets exposure.
How much exposure you have to emerging markets will depend on your individual investor profile – and you should consult an investment professional to help you make considered investment choices.
“You could argue that you already have emerging market exposure in the South African stock market. However, South Africa accounts for only a small percentage – about seven percent – of the emerging markets universe,” Dodd points out.
A recent study by investment company Cadiz showed that for a South African investor, the correlation of emerging markets as a whole to the JSE All Share index was so high that diversification could not be considered a plausible argument for investing in emerging markets.
However, Cadiz found that the justification for investment in emerging markets could primarily be based on compelling higher returns relative to local portfolios.
Challenges facing emerging markets
Although the overall outlook for emerging markets remains good, there are some challenges that remain, Acsis’s Andrew Salmon says.
“Some of the factors in favour of emerging markets are that they have large populations moving towards urbanisation, both governments and households have strong balance sheets, there are low levels of consumer penetration and there is |a high level of investment spend,” |he says.
However, Salmon says investors are moving capital out of emerging markets this year on the back of concern about rising oil and food prices and the resulting pressure of emerging market inflation.
According to Deutsche Bank, the effect of a severe oil shock could have significant implications for the GDP and inflation of emerging market economies, particularly those in Asia.
Salmon says other challenges facing emerging markets include:
u They need more balance between investment spend as a percentage of the economy and consumption. There is too much investment currently, which is unsustainable over the long term, and not enough consumption;
u While urbanisation is a good thing, emerging market economies need to be careful of over-urbanisation, which can cause economic, political and environmental problems.