Emerging markets are rebounding after a difficult early summer, when worries about rising U.S. interest rates and a slowdown in global growth hampered performance.
There are still concerns that the U.S. economy may slip into recession, but fund managers are confident developing countries are resilient enough to stand on their own and deliver further positive equity returns.
\u201cHistorically, emerging markets have been sensitive to scares of a global slowdown,\u201d says Patricia Perez-Coutts, manager of AGF Emerging Markets Value Fund<\/b> and vice president of Toronto-based AGF Funds Inc. <\/b> \u201cEven in the past, if we had a period in which interest rates were on the decline, this factor would not stem a potential market decline.\u201d
Perez-Coutts attributes the fall recovery to the perception that global growth will slow, but not to the extent feared.
\u201cBecause emerging markets are very resilient, because of restructurings in the past, there has been an interesting dynamic of coping with that perception of milder growth, but also supported by their own domestic economies,\u201d she says, noting that China, for example, is seeing 2006 GDP growth of around 11%.
To be sure, geopolitical issues such as the recent coup in Thailand and global agitation over North Korea\u2019s nuclear weapons program are negative factors. Yet, she notes, markets have taken those worries in their stride. Moreover, investors have reacted warmly to the drop in crude oil prices to US$60 a barrel from an earlier high of about US$79. \u201cWe have a lot of very happy markets,\u201d she says.
As well, Perez-Coutts adds, companies are reporting good earnings: \u201cMarkets are pinning their hopes on the expectation that this will continue.\u201d
The only fly in the ointment is a worse than expected global growth scenario. \u201cBut there is only 5% probability that will happen,\u201d she says. In her view, the fundamental picture in 2007 doesn\u2019t change. \u201cIt gets better,\u201d she says.
Mexico, for example, will institute reforms next year and expand GDP growth to exceed 4%. Brazil should benefit from the October re-election of president Luiz Inacio Lula da Silva, who has pledged to lower interest rates to boost the economy.
Turning to Asia, Perez-Coutts notes that the outlook for Thailand is improving; it should resume growth after a period of malaise. China, for its part, is taking steps to boost domestic consumption. \u201cThere\u2019s an array of expectations that should unfold in the next 12 to 18 months that are fundamentally positive,\u201d she says. \u201cThat is what supports the growth and stability of these countries \u2014 and consumption. We\u2019re very comfortable with that.\u201d
For the most part a bottom-up investor, Perez-Coutts has about 52% of her fund\u2019s portfolio in Asia, vs 53% for the benchmark MSCI emerging markets index. She is bullish on Latin America, which accounts for 33% of the fund, vs 19% for the index; but cautious on stocks in Europe, the Middle East and Africa, collectively known as EMEA, which accounts for 8% of portfolio, vs 27% for the index.
A top holding in the 84-name fund is Brazil\u2019s Banco Bradesco SA, one of the country\u2019s top banks and a survivor of the hyper-inflationary period of the 1980s and 1990s. \u201cIt\u2019s a restructuring story. It aggressively reduced its cost\/income ratios and generated much better returns on equity,\u201d says Perez-Coutts. Bought about four-and-a-half years ago at a multiple of one times price\/book value, it recently traded at 2.5 times book value. The bank generates a sustainable 25% return on equity, says Perez-Coutts: \u201cEven at 2.5 times book value, we believe Bradesco will enjoy significant benefits as a result of lowering interest rates.\u201d
Bought at an average share price of about 35 reals, it now trades at 77. Perez-Coutts has a target of 100 reals within three years.
Other large holdings include Mexico\u2019s Grupo Financiero Banorte SA and Lojas Renner SA, a fast-growing Brazilian apparel-retailing chain.
Gamaliel Blanco, a member of the emerging markets team that manages TD Emerging Markets Fund<\/b> for TD Asset Management Inc. <\/b> and portfolio specialist at New York-based Morgan Stanley Investment Management Inc.<\/b>, shares Perez-Coutts\u2019 optimism.
\u201cThe current bull run is not yet over, and 2006 is a mid-cycle correction year,\u201d says Blanco, who works with fund manager Ruchir Sharma, managing director at MSIM. \u201cThis summer\u2019s correction was more severe than two previous ones, as commodities also corrected from multi-year highs, which led to a change in risk appetite for the asset class.\u201d But emerging markets are in better condition than in the past, he adds, noting that nine of the top 10 markets are regarded as investment-grade, compared with only three a decade ago.
@page_break@\u201cThe concern about global growth has affected equity markets, but the economies remain very solid,\u201d says Blanco, adding that global growth could be 3%-3.5% in 2007, which is a supportive level for emerging markets. \u201cCurrent account positions, in aggregate, are in surplus, and currencies are under pressure to appreciate. These countries are in much better shape to withstand the slowdown in global growth.\u201d
Although there are divergent views on where the U.S. economy is heading, most economists are expecting a soft landing, says Jitania Kandhari, a senior analyst with MSIM who focuses on EMEA markets: \u201cA lot of growth momentum will be picked up by Asian countries. The overall expectation is for a soft landing, which helps make these economies more resilient than in past cyclical downturns.\u201d
Primarily bottom-up focused, the MSIM team favours stocks in Latin America, which accounts for 23.5% of the fund, including 10.7% in Mexico and 10.7% in Brazil.
Conversely, the fund is underweighted in Asia, which accounts for 41.6% of the fund. This can be attributed to the significant underweighting in South Korea and Taiwan \u2014 \u201cPrimarily because of the large cyclical component of the indices and the weakness of the domestic economies in these countries,\u201d says Blanco. The index has a heavy exposure to technology stocks in those two countries.
The team is enthusiastic about EMEA, which accounts for 32% of the fund. In particular, they favour investments in Russia, Poland and Turkey.
A top holding in the 180-name fund is a 2.6% position in Russia\u2019s OAO Gazprom. Despite being one of the world\u2019s leading natural gas and oil producers, it previously was a very small part of the index. That has changed; its weighting in the index was boosted to 5% last year, when the Russian government relaxed restrictions on foreign investment.
\u201cBut 5% is a little excessive,\u201d says Blanco, \u201cgiven our corporate governance concerns and the influence the government has over the company. As a result, we are underweighting the stock.\u201d
Nevertheless, as the team anticipates higher domestic gas prices in Russia, the fund also owns OAO Novatek, a mid-sized gas producer. \u201cWe\u2019re not putting all eggs in one basket with Gazprom,\u201d says Kandhari.
Other long-term favourites include Wal-Mart de Mexico SA, America Movil SA and Grupo Televisa SA, all from Mexico. Wal-Mart de Mexico follows the same strategy as its U.S.-based parent and continues to grow its market share, Kandhari says: \u201cThe quality of management is unmatched by any other name in the emerging markets.\u201d
The team also likes Grupo Televisa, which is benefiting from secular growth in TV advertising spending. \u201cIt\u2019s virtually in a monopoly situation. The firm is very well positioned,\u201d says Kandhari. The company is also developing a gaming business that could be a major driver of growth.
Emerging markets\u2019 returns should have been driven in the past few years by a mixture of strong commodity prices and underlying profit growth that was robust for cyclical reasons, says Austin Forey, manager of Mackenzie Universal Emerging Markets Capital Class Fund, <\/b> offered by Mackenzie Financial Corp. <\/b>, and managing director at London-based J.P. Morgan Asset Management. <\/b>
Yet, looking forward, he does not expect those factors to boost returns. \u201cOur outlook is not for anything like the nominal returns seen from 2002 to 2006,\u201d says Forey, a GARP investor who uses a blend of top-down and bottom-up analysis. Still, he argues, emerging markets will probably not experience the kind of macroeconomic crises of the past, such as the 1998 Russian ruble debacle.
\u201cThe next few years will be much more boring. But that\u2019s not a bad thing. We don\u2019t see within these markets the causes of another big problem. Fundamental conditions look all right, but they are quite advanced from a cyclical standpoint,\u201d he says, adding that a U.S. recession could make it tough to make money anywhere, not just in emerging markets.
Running a 65-name fund, Forey is focusing on companies for which growth is dependent on internal factors and less on cyclical trends. On a geographical basis, the fund has an overweighted 20.7% position in South Korea, as well as 14.2% in Brazil, and an underweighted position in Taiwan of 7.3%. There are smaller holdings in India and Russia.
Although company policy precludes him from discussing specific names, Forey favours companies in the retail and financial services sectors that tend to offer better long-term growth opportunities.
\u201cRetailing is a sector in which, if you find a winner, it tends to stay a winner,\u201d he says. \u201cStocks we have bought in the past have been those with favourable fundamental backgrounds, as well as outperformance from the company.\u201d Representative of the sector are Wal-Mart de Mexico and South Korea\u2019s Shinsegae Co.
In the financial services area, he favours Kookmin Bank, South Korea\u2019s largest bank; Mexico\u2019s Grupo Financiero Banorte; and Brazil\u2019s Banco Itau. The last stock is a play on the underdeveloped residential mortgage market that is coming into its own.
\u201cBrazil is a country in which banking has long-term potential,\u201d Forey notes. \u201cItau is one of the best-operating banks in that market.\u201d \tIE<\/b>
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