The bull's not ready for the abattoir as India and China are seen as a haven in shaky times, writes Fredrik Nerbrand
With emerging market equities soaring to record highs, driven by the seemingly insatiable appetite of investors to join the bandwagon, it is perhaps as good a time as any for a reality check. The renowned American Scientist Robert Oppenheimer once commented: "The optimist thinks this is the best of all possible worlds... the pessimist fears it is true.''
Indeed, it is useful to adopt this perspective towards emerging market equities and ask whether the emerging market bull has further to run.
After such a strong run, the near-term answer to this question is less clear, but if we afford ourselves a longer time horizon, looking at say three years, there are good reasons to remain firmly in the optimist camp. Let me start with some background.
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There is little question that the emerging market bull story has been the big investment theme for 2007. Rapid economic growth and soaring stock markets in emerging world countries such as Brazil, Russia, India and China (Bric) have provided handsome returns for investors, with the Morgan Stanley Countries Index (MSCI) Emerging Markets up a staggering 41 per cent year to date and 35 per cent since the middle of August.
But the emerging market story is not exclusive to 2007. The past five years in particular have delivered outstanding gains for investors in emerging market equities with annual returns averaging 38 per cent between September 2002 and September 2007.
These are remarkable returns by anyone's standards, and it seems everyone wants a piece of the action. Aggregate cumulative fund flows into emerging markets from investors have tallied an incredible $48bn so far in 2007.
This compares to $14.5bn and $10.6bn for the same periods in 2006 and 2005 respectively. Clearly, the emerging market growth theme is now not so much "emerging'' but very much in the mainstream.
And there is plenty to keep the bulls happy. Rapidly developing consumer and service sectors are supporting a buoyant corporate sector, while declining US dollar denominated debt in many emerging market countries and continued belief in the long-term strength in commodity prices have afforded emerging markets the unlikely status as a haven at a time when the developed world is working through the current turmoil in the financial sector.
But with all these factors coinciding to support record highs in emerging markets, it is entirely appropriate to ask if this is as good as it gets and is now an appropriate time to cash in my chips?
The answer to this question depends very much on the time horizon of the investor, but for investors willing to ride out any near-term volatility, we would argue there are still legs in the old bull yet. In support of this view it is interesting to look at emerging markets in the context of the global economy.
It may come as a surprise but, taken together, the emerging markets, including the Middle East, are actually the world's largest economic bloc. They account for 30 per cent of the global economy in terms of gross domestic product (GDP), a measure of economic output, denominated in US dollars.
By contrast, the equivalent proportions for the American economy are 25 per cent, and 24 per cent for Western Europe. Emerging markets are also by far the biggest contributor to global growth.
On the International Monetary Fund's estimates, emerging markets accounted for 47 per cent of the growth of the global economy in 2007.
Yet despite the prominence of emerging markets as an engine of global growth, emerging market equities account for only 11 per cent of the world's stock market capitalisation. The significance of these numbers, in our view, is that they demonstrate a rapid transition away from the developed world as the driver of global growth towards an emerging-markets-led global economy.
But how stable are emerging market economies?
We only have to go back to the last decade for evidence that things can fall apart quickly. In this regard, the strength and composition of emerging market economies have improved appreciably over the past decade.
Only 12 countries (out of the 40 for which statistics are available) now have total external debt higher than 50 per cent of GDP, while 56 per cent of the emerging market universe now enjoy current account surpluses compared with just 22 per cent in 1995.
Against a backdrop of drastically improved foreign currency reserves and stronger domestic consumption, emerging markets now appear far more resilient than in previous cycles.
The key to this success has been the shift towards greater domestic demand-led growth, reducing the emerging economies' traditional reliance on exports, while growing trade flows between emerging market countries should also enable them better to weather a moderation in export demand from the developed world.
With the macroeconomic story sound, the issue for emerging market investors becomes one of valuation, and at first glance emerging markets are beginning to look expensive.
Measured by the price/earnings ratio - that is, share prices expressed as a multiple of earnings per share - emerging markets are trading at 14.5 times 2008 earnings, a premium to their long-term averages and now near parity relative to valuations in developed world markets.
However, it is important to note that profitability is also at all-time highs which, together with improved capital discipline, should continue to drive impressive gains in earnings, and this should support continued solid long-term performance of emerging market equities in relative and absolute terms.
So, while the economic outlook appears intact, most of the good news is in valuations, and investors should not expect 2008 returns to be the same as 2007. Our global equity portfolios, therefore, have a neutral position to Emerging Markets. But there is still mileage in riding the bull.
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