Emerging Markets - Worth a Look?

In the wake of the world’s economic downturn, growth in developed markets is going to be very hard to come by. In emerging markets, however, growth could be much higher. This possibility is based on several pieces of evidence:

First, emerging-market economic fundamentals have improved over the past decade. Many emerging-market economies have reduced or eliminated their debt and have built up solid foreign currency reserves, making them less vulnerable to speculative currency attacks and allowing for more effective monetary policy.

Second, emerging-market corporate profitability has improved over the past several years and is comparable to, if not better than, that of the developed world. More and more emerging-market companies are shifting focus from survival mode to profit maximization. This focus shift, combined with generally low interest rates (and therefore low cost of capital for businesses), should keep profitability at a higher level. It would take a significant earnings decline or a significant rise in interest rates (or some combination of both) before the corporate profitability/cost of capital gap in emerging-market countries becomes negative. This is seen as a very low-probability risk.

Finally, per-capita income in many emerging-market countries has risen considerably over the past decade, stimulating internal demand. This is in line with the decoupling theory, which holds that some emerging markets (particularly China, India, and Brazil) now generate enough internal demand that they are no longer as dependent on export markets, such as the United States and Europe, to support GDP growth.

While the long-run outlook on emerging markets presents an intriguing opportunity, there could be substantial risk in the short-run. Emerging markets are much less dependent on exporting to the developed world than they have been in the past, and they have also reduced their reliance on foreign capital. This lower dependence on exports to developed countries and foreign capital doesn’t eliminate the risk from a slowdown in the developed world’s growth, but it is a mitigating factor relative to the past. While emerging markets’ dependence on the developed world for growth has decreased, investors may be too optimistic in assuming how independent emerging markets have become. The developed world had been growing at an above-trend rate. Now, as the growth trend of the developed world normalizes (first by contracting considerably), emerging markets could feel a significant pinch. The lingering effect of the global recession on emerging-market growth, as well as the valuation of emerging-market equities, remains to be seen.

The credit crunch resulting from the economic downturn is affecting emerging markets as well. Risk aversion among investors has increased greatly, which has led to losses of foreign, as well as domestic, capital in emerging-market countries. The capital that left emerging markets often fled towards the dollar, seen as a safer currency. The flight to the dollar caused a decline in emerging-market currencies relative to the dollar. This devaluation, however, is expected to be short-lived.

Finally, as the world emerges from the recession inflation could rear its ugly head. Higher inflation may mean higher interest rates and, as a result, lower valuation multiples for emerging-market equities than we have seen in recent years. Also, it may depress local consumption and, as a result, slow company-level earnings more than expected.

Despite the short-term risks associated with emerging markets, the long-term growth expectations show the asset class to provide a real opportunity. Better economic fundamentals, more effective monetary policy, and less reliance on the developed world indicate that emerging markets are worth a look.