We believe that investors should be heavily invested in emerging markets (see Prosperity Concierge’s long-term investment recommendations at Prosperity Trek III).
Investment advisory firm GMO made these observations in their 4th Quarter 2009 Quarterly Update:
We are “rationally exuberant” when it comes to emerging market equities over the long term. One of the key drivers of our bullishness is our view on the valuation of emerging markets (EM) relative to developed markets (DM). The valuation multiples that any market gets are based on the competing drivers of expected growth and risk.
While EM generally benefit from the perception of higher growth versus DM, they typically suffer from the perception of higher risk. And, quite often historically, the risk differential (EM vs. DM) has been significant enough to outweigh the benefit of higher growth. We feel that there is a case for this to change going forward
The case for continuing higher growth in EM (than DM) is relatively straightforward. EM generally do not have high levels of consumer debt or financial sector leverage. As a result, while the current crisis is more structural than cyclical for DM, for EM the converse is true. In a cyclical crisis, fiscal and monetary boosts are expected to work well. And the efficacy of governmental programs (snapback in GDP growth rates, record auto sales in Brazil and China, etc.) in EM shows that that’s indeed the case.
Another secular aspect working in EM’s favor is the large latent demand of consumers, which suggests that at the right price point it is easy to jump-start consumption.
EM are also reaping the benefits of favorable demographics. Specifically, the dependency ratio (proportion of non-working to working people) has dropped significantly in recent decades and is expected to stay there for the next few decades. This lower load on the working population means that they can spend less on supporting the non-working and can save or consume more. Indeed, the savings rate has climbed from under 15% in the early 80s to over 30% of GDP currently. This pool of savings presents a local alternative for EM to tap (for investment and/or consumption) in case there is a drop in foreign inflows.
The story on risk is not as clear as on growth. However, we feel that a close inspection will show that EM have narrowed the gap (versus DM) from both a macro and micro risk perspective. Their government financials are on a significantly sounder footing now than they were a decade ago. Both fiscal deficits and government debt loads (relative to GDP) have declined.
Other vulnerability indicators such as current account balances and credit are favorable relative to DM. Even the weakest link, export dependence on DM, is on an improving trend. The proportion of emerging exports that are accounted for by other EM has risen over time as these nations increasingly become consumers and not just suppliers to the West.
The micro picture of risk is just as important. The average company’s profitability (measured by return on equity) has converged with that of DM. There are several reasons behind this. Countries have largely abandoned fixed currency regimes, which led to an artificial cost of capital (quite often too high or too low). A clearer signal on the cost of capital has led to better capital allocation decisions. The Asian crisis has also led to a shunting of industrial policy in favor of a greater focus on shareholder value maximization. Finally, globalization of finance, which followed globalization of trade, has meant that corporate governance (including accounting standards) levels are much closer to DM than they were a decade ago.
Our own observations have led us to conclude that corporate managements now display greater professionalism and integrity than the earlier generation.
Putting it all together, we expect that EM will merit a higher relative valuation versus DM than they have historically. And this will be driven by not just their continuing ability to generate higher growth, but also by their strides toward reducing the fiscal, monetary, and corporate governance risk differential.
Related Information in Prosperity View
- Emerging Markets Still a Compelling Investment
- Emerging Markets: Decoupling Creating an Investment Opportunity
- Debt in Emerging and Developed Economies: A Reversal That Will Affect How We Invest
- Saving for Retirement Being Hurt by Economy & Attitude
- Follow the Money – Dump Treasury Bonds and Invest in Emerging Markets
- Emerging Markets Continue to Grow – Mark Mobius
- Emerging Markets vs. Domestic Companies: At Home Cash is Tight, Being Used to Pay Down Debt, Not Spending
- The Inflation Outlook and How It Should Influence Your Investments
