31st January 2011
There has been an increasingly noisy chorus suggesting that emerging markets may be past their prime. Inflationary pressures and rising interest rates may see investor returns eroded in the short-term, even if the long-term picture remains strong.
Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management, gives the other side of the story, showing why there is still life in the emerging markets story.
One of the strongest arguments against the ongoing success of emerging markets has been that comparative valuations with developed markets have narrowed to such an extent that investors are no longer getting paid for the risks they are taking. Poole says that while this is undoubtedly the case, there are sound structural reasons why the gap should be smaller: "There has been a structural shift in investors' portfolios. A bigger proportion of global economic activity comes from emerging markets and people are trying to reflect that in their asset allocation. Emerging market valuations have been supported by this process.
He says: "Developed markets were trading at around 17x earnings, compared to around 11x earnings for emerging markets at the beginning of 04. But this was before there was any idea of the extent of problems in the developed world."
"Now developed markets are trading at around 12x earning and emerging are still on roughly 11x.
"With improved data coming from the developed world this has led investors to reappraise the relative risk in emerging markets versus developed markets but the fact that the valuation gap has closed does not suggest, in itself, that emerging markets ar expensive given what we now know about relative fundamentals."
Poole also points out that there are significant anomalies in valuations between individual emerging markets. Russia, for example, is currently trading on 7x earnings, while India is trading on 15x. He believes Russia looks cheap compared to history and India looks, at best, fairly valued relative to its five year average.
He adds: "Markets have traded in a very correlated way since the crisis. Money has chased the ‘insular' markets such as India, which have strong domestic economies rather than being reliant on exports. This year, as the global recovery is looking more sound, the valuation differences between countries have been moving closer together. Markets are likely to favour more cyclical, export-driven markets such as China."
Emerging market debt funds also proved popular with investors in 2010, but there are worries that valuations have moved too far in the opposite direction. Poole admits that spreads over US treasuries have been compressed and are now at low levels, but points out that the relative ratings of developed and emerging markets have also moved closer together. Emerging market sovereign debt ratings have moved higher at the same time as developed market ratings are lower or under pressure.
Poole believes that 2011 is likely to be dominated by liquidity and the market is likely to be volatile. The higher yielding currencies will do well, as will a number of secular themes, such as domestic consumption. Infrastructure also remains compelling. The investment team at HSBC Asset Management is also backing commodities and with them, commodity-producing countries such as Russia and some of the Latin American markets.
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