Emerging markets have been resilient in the past year, buoyed by strong economic growth and improving fiscal environments. And although some managers are keeping an eye on high oil prices and rising interest rates in the U.S., which could throw a wrench into the works, they argue that strong fundamentals point to continuing good prospects.

“The short term will be driven by very strong macroeconomic factors,” says Paul Psaila, executive director at New York-based Morgan Stanley Investment Management and a member of the team led by Narayanan Ramachandran that manages TD Emerging Markets Fund for TD Mutual Funds Ltd. “Many countries have significantly improved their debt profile and have become net creditors. They have developed very strong balance sheets. The problems of the past, in terms of huge fiscal deficits, have been replaced by conservative policies, and surpluses in some cases.”

Emerging-markets debt is trading at a rock-bottom 250 basis points more than U.S. 10-year treasury bonds, or 6.75%. “Debt spreads have never been tighter,” he says.

Admittedly, conditions could become challenging. The U.S. Federal Reserve Board has jacked up interest rates to squelch inflation in the U.S.. “That is the biggest source of risk,” says Psaila. “But assuming a mistake is not made in the U.S.’s monetary policy or elsewhere, the macroeconomics in the medium term point to a fairly good outlook. There is no source of systemic crisis on the horizon.”

Indeed, he argues, the crises of the past are fresh enough to prevent future calamities. For instance, Russia, which saw its currency crash in 1998, has made a stunning recovery. Today, it has significant fiscal surpluses that allow its government to create a stabilization fund based on oil revenue. “It remembered the crisis of the past and created a rainy-day fund, which has grown to US$30 billion, despite also paying down US$15 billion in debt.”

Turkey is also back from the brink. In the past two years, its government has delivered a fiscal surplus every two months that is equivalent to an annualized 6.5%. “There isn’t a developed country that could do this. Turkey did it because it woke up after 40 years,” says Psaila. “This is the most important trend within emerging markets, and it will bolster stock markets. As long as there’s not instability, equity markets should do OK.”

The team, which blends top-down and bottom-up investment styles, favours the consumer discretionary and durables sectors because of high earnings growth and strong visibility; it is neutral in energy and is underweighted in materials and telecommunications because of poor visibility.

Russia overweighted

On a country basis, they like Russia, giving it a 10.3% weighting, vs 5.3% in the benchmark. Brazil accounts for 13.2% of the fund, vs the 10.5% index weighting; South Africa, 12% (vs 10% in the index); Mexico, 10% (vs 6.1% in the index); and Turkey, 4.7% (vs 2% in the index).

One of the top holdings in the 200-name fund is OAO Lukoil, with a 4% weighting. Russia’s leading oil company, it has reserves equivalent to 20 billion barrels of oil and benefits from high refining margins. “It will also become a fairly large natural gas player, which the market underappreciates. Lukoil will monetize its gas supply so both the volumes of gas and the prices it receives will rise, which gives a nice compounding effect,” Psaila says. He notes Lukoil is also one of the world’s cheapest oil companies and sells for the equivalent of about US$2.50 a barrel of oil, vs US$14 for Exxon Mobil Corp.

The stock, which trades on the New York Stock Exchange as an American depository receipt, recently traded at US$54.60 a unit, vs US$30.75 at the start of the year. “With the higher oil price, you get a benefit out of Russia from the cheap asset valuations,” Psaila says. In a similar vein, he likes Brazil’s Petro-Bras SA and Companhia Vale do Rio Doce (CVRD), the world’s leading iron ore producer.

The macroeconomic outlook remains positive now that worries about inflation have subsided, says Patricia Perez-Coutts, manager of AGF Emerging Markets Value Fund and vice president of Toronto-based AGF Management Ltd. “Despite the higher oil and commodity prices, there is enough competition among manufacturers that they can’t pass on higher prices to consumers. And the combination of productivity increases and stronger currencies have kept inflation away.”

@page_break@Central banks in Brazil and Mexico have been lowering nominal interest rates, although real rates are still about 13% and 5%, respectively. “There is a better environment for long-term sustained growth as a result of falling rates and lower inflation,” she says.

So far, the year “has unfolded much nicer than I expected,” says Perez-Coutts. “Now that oil has come off to about US$63 a barrel, that’s positive for Asia. And inflation is not such an issue as it was earlier. With the trend toward lower interest rates, the longer-term picture becomes much clearer to us. So long as inflation does not come back and China does not crack — the two biggest risks — the long-term picture is good. The benign environment is back again.”

She notes China’s growth remains robust at more than 9%, driven partly by strong consumer spending and massive infrastructure building in less-developed areas in its interior.

For the most part a bottom-up investor, Perez-Coutts has about 16% of the portfolio in Brazil; 12% in China and Hong Kong, vs 8% in the index; 10% in India vs the index’s 6%; and 12% in Mexico. South Africa is modestly underweighted at 9%; South Korea is underweighted at 13%, vs 17% in the index; and Taiwan is extremely underweighted at 3.5% (vs 17%) because its stocks have only recently become attractive.

On a sectoral basis, Perez-Coutts favours consumer discretionary and staples, but maintains neutral or close to neutral weightings in energy, materials, financials and real estate. Information technology and telecom are only modestly represented. “The next leg in growth has to come from consumers buying things, on cash or credit,” she says. “Credit growth has not been there yet, so I’m still very positive.”

Petrobras a favourite

One of the top holdings in the 80-name fund is Petrobras of Brazil. “Throughout the past year, its production profile has been strengthening,” Perez-Coutts says. Production is expected to grow 10%-12% a year over the next five years and it boasts a 29% long-term return on equity. “It is one of the best plays production-wise, more so than the Exxon Mobils of the world,” she says. Yet the stock trades at 5.7 times cash flow, or a 20% discount to the majors, because of perceived higher political risk. Acquired in 2001 at an average price of 12.5 reals a share, it recently traded at 32.1 reals.

Another favourite is Korea Electric Power, one of the leading utilities in South Korea. “Its Achilles heel has been high-priced oil, but it has been able to pass on some price increases,” says Perez-Coutts, noting the stock trades at 7.5 times earnings. “The offset is that the Korean won has strengthened against the [U.S.] dollar. Meanwhile, demand has been sustained so the fortunes of the company have improved. When oil comes off some more, it will do even better.” Bought in July 2002 at 15,000 won a share, it recently traded at 35,000 won.

Equally bullish is Edward Baker III, manager of BMO Emerging Markets Fund and London-based chief investment officer of emerging markets equities at Alliance Capital Management LP. “Markets continue to be reasonably valued, relative to developed markets,” says Baker. “On a price/earnings basis, they trade at a discount equal to the historical average, which is 30%. The question is: are they undervalued? That depends on your view of why this discount persists.”

Although an equity risk premium has been built into these stocks, Baker argues that they are less risky than in the past. He cites improved current account balances and high levels of foreign exchange reserves in many countries, with exceptions such as Hungary. “The currency-led crises of the past are unlikely to happen in the near term,” he says.

GDP growth looks more attractive in emerging markets than elsewhere. “It’s more driven by domestic demand than in the past,” says Baker. “This makes it less vulnerable to external shocks. [Such markets] are less tied to global growth patterns.”

On the negative side, he notes, rising rates in the U.S. could have a shock effect on markets. “With the energy crisis we’re facing, there is potential for inflation spiking, which could result in fiscal tightening,” says Baker, adding that India and Indonesia, net importers of oil, could see problems because their governments try to control prices at the consumer level. Markets could see capital outflows if inflation worries get out of hand, he adds, although “these worries don’t seem imminent.” On balance, he expects positive outperformance relative to developed markets and positive absolute performance.

Baker has a modestly underweighted 50.6% position in Asia (13.5% in Taiwan, 17% South Korea and smaller weightings elsewhere), and has a neutral 26.3% mix of eastern Europe, the Middle East and Africa, and a slightly overweighted 23.1% in Latin America. A growth at a reasonable price, bottom-up investor who uses a top-down view for risk control, he runs a 130-name fund. Leading holdings include Petrobras, Brazil’s CVRD and Lukoil.

A large holding is a 4.5% stake in Cathay Financial Co., a leading retail bank based in Taiwan that should benefit from financial services restructuring there. “Its asset portfolio is being revalued upward, leading to strong earnings gains,” says Baker. Acquired a year ago, it recently traded at TWD$61 a share, or 15.8 times 2006 earnings. IE