Are the emerging markets at risk of bubbling?

Back in 2003, global investors had around $600 billion more in emerging markets than might have been expected, given their size relative to global stockmarkets. By early 2009, that had sharply reversed and global investors were $400 billion underweight in these regions.

Yet, since 2003, emerging markets have almost trebled, while the world index, dominated by developed countries, rose by less than a third of 1%. In 2009 alone, the return from emerging markets was more than three times that of global markets as a whole.

It is no surprise that investors piled into emerging markets in 2009. More than $50 billion was invested in these regions, although that did little more than replace what was withdrawn the previous year.

This worries Slim Feriani, chief executive of Advance Emerging Capital. He thinks the weight of money heading for Brazil, China and India, in particular, means there is a real risk of a bubble developing.

"[Emerging] markets are small and not deep enough to absorb [large amounts of investment]. If another $50 billion was ploughed in, markets could rise another 50%. Then there would be a risk of a scramble to invest by institutions and individuals."

He is particularly keen on Brazil and Russia, partly because of their huge wealth of natural resources. Recent oil finds off Brazil's shores could hold 50 billion barrels, putting it in the major league of oil producers. Russia's proven reserves are already higher than that.

African countries are rich in the minerals and industrial commodities that are being sucked up by China for its huge infrastructure developments.

However, Feriani says these countries should not be seen as pure commodity plays. He points out that, even with its huge resource wealth,  exports account for just 10% of Brazil's economy.

"The real driver in Brazil is the domestic engine. The country has a population of 200 million and there is a rapidly growing affluent middle class."

The country will host the World Cup in 2014 and the Olympics two years later. "They know they need to invest in infrastructure for these events," says Feriani.

Popularity problem

Jeff Chowdry, manager of the F&C Emerging Markets fund, shares Feriani's concern that emerging markets could become too popular. "Markets have moved from extremely undervalued to fair value. But earnings growth should be more than 20% in 2010."

That, Chowdry says, means emerging markets should make good progress in 2010, even if valuations, based on price/earnings ratios, do not grow further. It is "not impossible" that emerging markets could get back to their 2007 peaks.

He favours eastern Europe, the Middle East and South Africa. "We liked Russia throughout 2009. It has risen 130%, but we think there is more to come. Earnings growth in 2010 is likely to be 50%.

"Similarly, Hungary and other eastern European markets have been beaten down, but have recovered now and we expect inflows into them."

In 2009, there was a big divergence in performance between different emerging markets, with Asia and Brazil particularly strong (Brazil is one of the best-performing markets over the decade), while the rest of Latin America and the Middle East did poorly. Chowdry expects more equal performance in 2010.

He thinks the biggest risk to emerging markets is a double-dip recession in the developed world.

The onset of the financial crisis saw dramatic destocking among Western companies as they strove to slash costs, then panic restocking as they realised the recession was not going to be as bad as they thought. Weakening demand would be bad news.

China is the big market for emerging market specialists, but views vary over its future. Philip Ehrmann, manager of Jupiter's China fund, thinks the Chinese authorities proved adept at "dodging the rapids" caused by the financial turmoil in Western economies with their $600 billion of domestic stimulus packages.

"In the fourth quarter of 2008, growth was flat, but we are likely to close 2009 with GDP growth of 8.9%. Banks are lending, confidence has returned, retail sales and property transactions are rising, so the government can ease off on its stimulus."

Because of weakness in developed markets, Ehrmann prefers domestic consumer-oriented stocks. He points out that more LCD televisions were sold in China last year than in the US, while car sales in China have been rising by at least 70% a month and it is now the world's largest car market.
He expects investors to start worrying about inflation again later in 2010, but he is not particularly concerned about that threat. "China will ease off on its stimulus. The government's role is to act as a counter-cyclical influence on inflation," he says.

Glen Finegan, portfolio manager at emerging markets specialist First State, thinks investors have got carried away in their excitement about China's 1.2 billion consumers and "have forgotten about risk".

The firm's investment approach is 'bottom-up', which means its fund managers look for attractive companies regardless of what sector or country they are in.

He says it is getting harder to find good companies at sensible valuations because the surge of interest in emerging markets from Western investors has pushed prices up sharply.

"Valuations in China are in La La Land," he says. "Brazil valuations are very high, especially given that interest rates are also very high and you can get a good risk-free return in the bank."

Further afield

That is persuading him to consider less established emerging markets, such as South Africa, Mexico and Argentina. "South Africa is still quite cheap and has some of the best run companies in emerging markets."

He likes companies such as Walmex, the Mexican subsidiary of US retailing giant Walmart, and Shoprite, a South African food retailer expanding into countries such as Nigeria, which are, says Finegan, a "huge consumer opportunity".

He adds: "And there is no competition because rivals like Carrefour and Tesco are focusing on China. You can buy Shoprite on a price/earnings ratio of around 14, while the equivalent in China would be 26 times."

Mike Kerley, manager of Henderson Far East Income investment trust, thinks 2010 will be much more subdued for Asian economies.

"The last four or five months have all been about the snap back in global economies, not the sustainability of Asian growth. I struggle to say that it is sustainable."

He points out that 60% of China's imports come from elsewhere in Asia, which should be positive for the region.

Like Ehrmann, he prefers the domestic-oriented Chinese stocks, with 80% of his portfolio in financial companies and property operations, and those that will benefit from infrastructure spending.

Brazil, Indonesia and Turkey are the favourite markets of Paul Wimborne, manager of Baring Emerging Markets fund. "All three have made the transition to fully functioning democracies," he says.

"They have large populations and strong banking systems, and all have made significant political and economic progress in the last 10 years.
"Previously in a downturn, they would have been basket cases, as they once had 70% inflation and 40% interest rates. But in the last five years, they have made dramatic progress."

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

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