Globalization Lives
It is widely acknowledged that emerging economies will play an increasingly important role in the US, and global economy, in the 21st Century. While reportedly more than half the members of the US Congress do not own a passport, the United States is increasingly integrating with the world economy, even though many observers expected the aftermath of September 11, 2001 to lead to a sharp slowdown in global trade. To cite just a few metrics: Mexico and China are now the US’s second and third largest trading partners; and non-Japan Asian Central Banks (including China, Korea, and Taiwan) now hold 40% of world reserves, the vast majority of which are held in dollars.
This paper briefly describes the characteristics of emerging market equities, and outlines the case for both institutional and retail investors to hold a portion of their portfolios in emerging markets. A world market weighting in emerging markets would suggest holding about 5% of equities in this asset class.
An Overview of Emerging Market Equities
Emerging markets are characterized by diversity, volatility, rapid economic growth and frequently, immature institutions. The Morgan Stanley Capital International Emerging Markets Index (MSCI EMF), one possible proxy for the asset class, currently contains 730 securities in 26 countries with an aggregate capitalization of $1.1 trillion. Countries run the gamut from Taiwan and Korea, with per capita incomes well in excess of $10,000, to Sri Lanka where per capita income is below $1,000.
The Strategic Case for Emerging Markets Diversification
As one would expect, as countries remove capital controls and increase trade openness, the correlation of emerging markets has gradually increased to about .75 with US equities. But, despite their volatility, by adding emerging markets to their portfolio, investors can create more efficient portfolios.
Return Enhancement
The second reason for investing in emerging markets has to do with return enhancement. Over the past 15 years, emerging market equities have outperformed global equities by nearly 400 basis points per annum.1 Each year, one emerging market is frequently the best performing market in the world. Asia, led by China, is and will likely continue to be the world’s most rapidly growing region. Output in China is growing at roughly 8% per annum; China represents a favorable shock to both global demand and supply.
Given faster economic growth in emerging markets relative to developed markets, Plan sponsors often posit a long term 1-2% return premium (relative to developed market equities) for emerging market equities. Certainly emerging markets can have large runs: For example, over the past two years they have returned a cumulative 85%.2
Broader Opportunity Set
It is sometimes said that it is companies, not markets, that emerge. Gazprom is a Russian company that earns nearly $6 billion a year and supplies roughly 20% of Germany’s natural gas reserves. Its natural gas reserves are among the largest in the world.
In emerging markets, there are “asset plays”, growth stories and restructuring plays, among others. Many companies in emerging markets have absolute advantages, either in terms of labor costs or raw materials. By including emerging markets in the opportunity set, investors can access some world class companies, such as Samsung and Infosys.
The Tactical Case for Emerging Markets
Currently emerging markets sell at about 10 times forward earnings, a sharp discount to the forward earnings multiple of developed markets. We believe the outlook for global economic activity in 2005 is strong. And Asian currencies are likely to continue to appreciate over time. While it is unrealistic to expect returns from emerging markets like the last two years, emerging markets are attractively valued in a global context.
Conclusion
Several themes will characterize emerging markets investing in the decade ahead. These include the rise of China as a global manufacturing center, the growth of inter Asian trade, the emergence of Russia as major energy supplier, the enlargement of the EU, outsourcing, and the wiring of the emerging world, to name a few. Most investors continue to be underweight in non-US equities and, in particular, emerging markets. Political and other risks in emerging markets are substantial, and investors should carefully limit their allocations. But adding emerging markets to a portfolio can both increase return and diversify risk.
For further information please contact:
Penrose Financial
Sally Todd/Rob Ridland Tel: 020 7786 4815/4869