EVEN as the International Monetary Fund and World Bank recently downgraded their forecasts for global growth in 2012 and 2013, emerging markets (EMs) remain a bright spot, with long-term structural themes of increasing urbanisation, favourable demographics and a growing middle-class expected to propel their economies forward.
In this update, we look at three reasons not to ignore EM equities which are currently our favourite regional equity market with a 5.0 star ‘very attractive’ rating.
Reason 1: Too large to ignore
Even as many investors still view EM equities as a peripheral ‘satellite’ investment, the representation of EM countries in the global economy has grown by leaps and bounds.
Based on the latest forecasts of the IMF, EM economies will increase their representation in the global economy to 43 per cent by 2017, up from 38 per cent presently (in 2012), and significantly more than the 23.5 per cent in 1980,a function of their quicker pace of economic expansion.
Simply put, over the course of the next five years, EM economies will make up nearly half the global economy, which will make the region too large to ignore by investors.
Investment Implications:
Despite their rising importance to the global economy, EM equities remain under-represented as a percentage of global equity market capitalisation, as well as within investor portfolios.
As mentioned earlier, EM economies (based on the IMF classification) will make up 38 per cent of the global economy (in nominal US dollar terms) in 2012. In contrast, their respective stock markets had a market capitalisation of US$10.6 trillion (as of October 12, 2012), making up just 21.1 per cent of global stock market capitalisation.
The breakdown of US equity mutual fund allocations also highlights how retail investors still have a fairly low allocation to a region which could make up nearly half the global economy in the near future.
As of end-August 2012, assets of EM equity funds made up just 3.6 per cent of total equity fund assets, suggesting that EM equities are still viewed as a supplementary or periphery allocation by global investors like those in the US.
Reason 2: Strongest growth prospects
‘Growth’ continues to be a central theme for investing in EMs, and it is heartening to note that despite the latest downgrades in growth forecasts, the long-term trend in EM growth remains intact, the implications of which are worth highlighting here.
In addition to their rising representation in the global economy, the increasing influence of EM economies is even more evident in terms of their contribution to global economic growth.
Measured in terms of nominal GDP (on current US dollar terms), EM economies now contribute more to global growth vis-à-vis their developed nation counterparts, a trend which is expected to continue into the foreseeable future.
For example, for 2012, EM economies are expected to deliver 2.4 percentage points of GDP growth, offsetting a -0.4 percentage point contribution by the rest of the world.
This trend is also forecasted to continue over the next five years, with an average of 60 per cent of global growth each year from 2013 to 2017 attributed to EM economies.
This phenomenon is a function of the quicker anticipated pace of growth of EM economies; this is especially poignant in an environment where advanced economies (like that of the G7) are forecasted to experience fairly muted growth.
From 2012-2017, EM economies are expected to post real (inflation-adjusted) GDP growth of six per cent per annum (p.a.), which compares extremely favourably to the 2.2 per cent p.a. and 2.3 per cent p.a. expected of the G7 and the advanced economies respectively.
Investment Implications:
Earnings growth is a key driver of long-term stock market and the quicker economic growth rates of the EMs should invariably translate to higher sustainable rates of corporate earnings growth, which should result in stronger gains for EM equity investors over the longer term.
The stronger relative growth of earnings for EM companies has already aided in the outperformance of EM equities (a 14 per cent annualised return compared against the 5.2 per cent for developed markets) over the past decade (from end-2001 to end-September 2012), as EM companies posted a superior rate of earnings growth (11.3 per cent p.a. compared with 7.4 per cent p.a. for developed markets).
In addition, investment capital tends to flow towards assets where higher returns can be achieved and in the current environment where most advanced economies are expected to post modest rates of growth, we believe this should see EM assets increasingly find favour amongst global investors.
Such a trend already appears to be playing out, with mutual fund flows in the US indicating that despite the overall outflows from equity funds so far in 2012 (as of end-August 2012), EM equity funds have still seen net inflows on a year-to-date basis.
Reason 3: Positives are currently underpriced
Given the growth disparity, stronger expected returns and increasing influence of EM economies, one would expect to find the segment trading at a steep premium to developed market equities.
However, this is presently not the case, with developed markets (represented by the MSCI World) actually trading at a premium to the MSCI EM.
A possible reason for this is the higher perceived investment risk in EM equities (higher ‘beta’ nature of EM equities), evidenced by the higher equity market volatility figures – since 1995, EM equities have demonstrated an annualised volatility of 25 per cent, higher than the 16.2 per cent for developed equity markets (as of end-September 2012).
Investment Implications:
Despite their higher volatility, we continue to believe EM equities offer a compelling investment opportunity at this juncture, with market valuations below that of the developed markets, as well as the segment’s historical average.