The revival of emerging markets

“Emerging markets are no longer a homogeneous group,” says Christine Tan, chief investment officer with Excel Investment Counsel Inc. of Mississauga, Ont. and portfolio manager of Excel Emerging Markets Fund. “Low oil prices, for example, are bad for big producing countries in the Middle East but amazing for India, which imports 80% of its oil.”

Mark Mobius, executive chairman of Templeton Emerging Markets Group, a division of U.S.-based Franklin Templeton Investments, in Singapore, has seen emerging-markets assets managed by his firm soar to US$27 billion from US$100 million in 1987 when he began working with the firm.

“More and more countries are realizing the benefits of having free market economies, and are opening up to investment,” he says. “In 1987, there were only five emerging countries to invest in — I can now invest in more than 80 countries. It’s been an incredible ride. And the story is not over yet, there are still many countries struggling to develop a market economy.”

The sheer size of emerging markets indicates their potential influence on global economics as they develop. More than six billion people live in emerging markets, including 90% of the world’s population under 30 years of age, a high-consuming demographic, Tan says. The median age in Canada, for example is 41.8 years, while it’s 36.8 in China, 27.3 in India and 31.1 in Brazil.

As such, emerging-markets equities could account for more than 60% of global market capitalization by 2050, says Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania and well-known author, compared with 10% today, based on the MSCI emerging markets index. In less than 15 years, as much as 60% of the world’s middle class will reside in emerging markets.

Although emerging markets tend to be volatile, they’re moving away from the boom-and-bust cycle that characterized their early development. Stock picking now requires a greater depth of research on individual companies rather than top-down analysis of geographies or sectors, Tan says.

For the 15 years ended July 31, 2016, emerging markets showed a total average annual return of 9.1%, as measured by the MSCI emerging markets index, almost double the 4.7% return of the MSCI world index.

The past few years have been tough on emerging markets, however, as nervous global investors anticipating interest rate hikes have sought the perceived safety of large, better known markets, such as the U.S. But interest rate hikes have been slow to happen, and the gradual hiking pattern now anticipated would have less impact than previously expected.

This year, emerging-markets investments have been reviving as concerns rise that developed-markets investments have become expensive. Sluggish economic growth in the U.S., an unpredictable election this year, terror attacks, financial troubles in the European Union and the surprise result of the Brexit referendum in the U.K. have all contributed to the shift in perspective.

“There has been a flight to safety, but after underperforming for a few years, emerging markets are much more attractively valued than they were, and offer better earnings growth potential going forward,” says Gerardo Zamorano, director of investments with San Diego-based Brandes Investment Partners LP. “We’re seeing a wide valuation gap.”

The MSCI emerging markets index had gained 9.8% year to date as of Aug. 15 compared with a decline of 0.5% for the MSCI world index. And there was still room for valuations to improve with emerging-markets stocks trading at 12 times projected earnings compared with a multiple of 16 for world markets.

“Events such as the Brexit vote show there is risk everywhere,” Mobius says. “Every event has consequences, and some present opportunities. For example, if the U.K. is faced with restrictions on goods exported to Europe, it’s likely to move some of its manufacturing offshore to places like Eastern Europe, where labour costs are lower. British industries such as household goods, clothing and even tea packaging, have already moved away.”

Although there have been concerns about China’s economic slowdown (to about 6% this year vs previous highs of more than 10% a year), most experts are confident in a soft landing. China’s government is focusing on stimulating the economy, but there are some concerns about high levels of corporate and government debt.

Nevertheless, China is the engine that drives many other emerging markets because of its voracious appetite for raw materials and powerful influence on regional trade, says Jonathan Lemco, senior investment strategist with Malvern, Penn.-based Vanguard Group. As long as China’s growth does not slow to a hard landing of 3% to 4%, it should stay out of the danger zone.

“China’s rate of growth is absolutely slowing down, and with its expanding economic base, that’s a good thing,” Tan says. “It’s now a US$15-trillion economy, and cannot grow at 8% to 10% without causing inefficiencies and distortions.”

There’s some excess capacity in older industries in China, such as cement and steel, and factories are closing, she says. Opportunities are arising in education, health care and environmental industries that require a higher level of training and offer better quality jobs.

“It’s about owning specific businesses rather than countries,” Tan says.

This is the first article in a three-part series on emerging markets.

Up next: Opportunities in India.