Can emerging markets keep up the pace?

The four biggest emerging economies - Brazil, Russia, India and China, often referred to by the acronym BRIC - have been enjoying trend GDP growth of 7% to 8% a year, compared with an average 2% to 3% in developed countries.
Investment experts agree that the long-term emerging markets story is compelling and that the BRICs will outperform developed economies over the next decade.

So this is just the kind of long-term turbo-charged investment that could quickly give rise to a capital gains tax liability and is well suited to the tax shelter of an ISA.

However, emerging markets stocks rose a record 75% last year and their tremendous run since 2008 caps further immediate progress. So investors might be advised to wait for better buying opportunities in the event of a small setback.
In particular, these markets could falter as central banks begin tightening their policies in response to the recovery.

For instance, markets across the region got the jitters in early January after China's central bank raised the interest rate on its three-month bills in a bid to curb lending growth.

"We are concerned that too much optimism is priced into these markets, and would warn ISA investors that it would be foolish to extrapolate the same returns going forward," says Gary Potter, co-head of Thames River Multi-Manager.

"We would not be surprised to see a 10% to 15% correction in these markets at some point this year.

"The potential for inflation is a particular concern and recently China's central bank has made noises about the amount of capital the banks must secure before they are allowed to lend. More bad news could wipe 10% or even 20% off the market just like that."

Growth drivers

However, over the long term the massive drivers for growth remain unchanged. Young, skilled and well-educated workforces are moving en masse to the cities and are developing a taste for all things western, from fashion to food and financial services.

Half the world's 6.7 billion people live in BRIC countries and at current growth rates the world's population will rise by 2 billion by 2040, with the vast majority of the additional headcount living in these regions. China's population alone is expected to explode by 150% in the next 30 years.

Arguably, 60% to 70% of a country's GDP is consumer-driven, and companies supplying products that play directly into consumer prosperity, such as healthcare, personal care and telecoms, are experiencing extraordinary growth.

Car consumption in China is up 80% year-on-year, while mobile phone penetration is still only 30% compared with 120% to 130% in Europe.

Sales of financial services should also balloon as savings rates across these regions are high and products such as loans and mortgages begin to be marketed.

As emerging economies enter this sweet spot in terms of shifting demographics, many developed nations, most notably Japan, are demonstrating how difficult it is to thrive with an ageing population, and are seen as a route map for where Europe is heading.

The financial systems in BRIC countries have also remained intact, avoiding the deleveraging process facing the rest of the world. Non-performing loans, for example, are running at around half the level in mature economies.

Emerging nations have also transformed their current account surpluses and foreign exchange reserves, which are now in better shape than at any time in the last century. Russia, for instance, has $400 billion (£247 billion) in reserves.

Increasingly, the commercial and manufacturing competitiveness of emerging markets, particularly in respect of labour costs, is exerting huge pressure on European and US businesses.

For example, a German auto assembler earns €45 per hour including benefits, compared with just €1 to €2 for the equivalent Chinese worker. This competitive edge is no longer limited to cheap labour; systems, processes and infrastructure are also improving.

China's power stations, for example, are typically 30% to 40% cheaper to run and are rapidly upgrading to similar levels of quality and service.

Workshop of the world

The world's technological toys, such as the Apple iPhone, ebook readers, GPS systems and the Nintendo DSi, are now almost exclusively manufactured in China and a few other Asian nations.

Domestic spending on technology is also expected to be boosted by businesses looking to increase productivity and to replace existing computers, which are estimated to be five years old on average, compared with the normal 3.5 year life of the Western corporate computer.

The sheer weight of money has helped drive up these markets, while a shift in attitudes to emerging markets equities based on a new widespread conviction that these markets will actually deliver, is itself providing momentum.

"Most investors are structurally underweight in what is the most interesting investment story of the decade,' says Claire Simmonds, client portfolio manager for emerging markets equities at JPMorgan.

"From currently 12% of global equity markets, we believe emerging markets could rise to 42% of global equity markets by 2029. It is worth recalling they were just 1.6% of global equity markets in 1989."

But the structure of the investor base also makes these markets more vulnerable.

Relatively little is institutional money because the level of insurance and pensions money under management is small compared with developed markets, so any activity from foreign capital or local speculators will have a greater impact.

Political stability also remains an issue: legal structures are relatively immature, bureaucracy and red tape can prevail and corruption is commonplace in certain sectors with regulatory or pricing issues.

In the longer term, the gaping Gini coefficient, a statistic that shows wealth inequality, could exacerbate instability, as could China's one-child policy and resulting imbalance between the sexes.

Ultimately, fewer women also beget fewer children and young workers to support a burgeoning older population.

Different strengths

Individually, the BRIC countries are very different economies. China could still be characterised as the workhouse of the world and its stockmarket is heavily weighted to financials, which account for about 45%, and the telecoms industry which represents 17%.

India could be characterised by outsourcing and is a little more balanced than the others, with financials, energy, commodities and IT accounting for about 70% of the market.

Russia and Brazil are both plays on commodities, which inevitably mean higher volatility. Oil and gas make up about 50% of the Russian stockmarket, while commodities, energy and financials are 75% of the Brazilian market.

Russia is currently cheapest on a price/earnings multiple of around 12 or 13, while China is trading on 20.

"The Russian and Brazilian economies are both dominated by oil and commodities," says Justin Modray, founder of "This has meant lots of volatility in recent times, although the partial oil price recovery provided a welcome boost to 2009 stockmarket returns.

The BRIC economies have suffered from the global downturn, but generally to a lesser extent than western economies such as the UK and US."

He adds: "Barring any unexpected shocks, 2010 will be a reasonable year for BRIC economies, but I'd favour cautious fund managers until the world's economies are more firmly out of recession.

"For most investors it makes sense to access these economies through general emerging markets funds to provide greater diversity. The risk of buying country-specific funds is that BRIC economies tend to be dominated by a handful of sectors."
For some fund managers, the concept of restricting investment to BRIC countries alone is considered an artificial distinction and one that could preclude exciting opportunities in other immature markets.

"While there is no doubting the importance of these populous countries that are already among the main contributors to global economic growth, BRIC is a 'top-down' idea that can create a distraction, restricting the investment universe," says Devan Kaloo, head of global emerging markets at Aberdeen Asset Managers.

"Quality companies are thin on the ground in Russia and mainland China, and our portfolios have been underweight these countries for some time, because we have found better opportunities elsewhere.

"We prefer to access Chinese growth via Hong Kong-listed stocks like China Mobile."
He continues: "Meanwhile, our portfolios have been overweight India and Brazil - not because of any BRIC-related view, but simply because we have found good companies in those countries.

"We favour domestically focused stocks, because we believe emerging economies will become much more domestic growth-driven in future, thanks in part to young, growing populations that will boost earning and spending power.

"While Brazil and India offer quality companies that are well placed to profit from domestic growth, there are opportunities away from BRICs too, including in South Africa and Turkey."
Some wealth managers are beginning to offer a more nuanced approach, with funds of certain styles such as value and growth funds, or in JPMorgan's case a total return fund (EM Alpha Plus); a relatively new concept for this asset class that uses the Ucits III framework to go short as well as long.

"I think BRIC funds are generally a good idea," says Darius McDermott, managing director of Chelsea Financial Services. "Clearly, they are less diversified than a general emerging markets fund and as such are higher risk.

"They are very volatile and tend to have periods of strong performance and underperformance, but if you hold on for the longer term they should do well, and with their high volatility it may be a good idea to buy on a monthly basis to get some pound-cost averaging."

This article was originally published in Money Observer - Moneywise's sister publication - in March 2010

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