Emerging markets – still a good long-term investment opportunity
Conditions have been difficult for both developed and emerging world stock markets lately but investment opportunities remain. And there are good reasons to believe that the fundamental outlook for emerging economies and their potential to outperform developed world markets over the long term is still strong.
This conviction is driven by superior growth prospects and growing investment in emerging markets by developed world investors and the rising prosperity overall of emerging nations.
While it’s true that emerging market equities have underperformed this year, given the level of uncertainty in markets and concern among investors, a few percentage points of relative underperformance against developed market equities is perhaps not very significant. One of the characteristics of emerging market equities is their volatility, with sentiment and share prices shifting on almost a daily basis in response to news (such as Greece’s default potential) that comes primarily from developed markets.
A reversion to a long-term trend
But at a time when many are fixated on very short-term events, it’s worth exploring the very long term. It seems that we are merely reverting to a trend, to a world that is much more balanced in terms of trade and output. If you go back a couple of hundred years, for example, what we consider now to be emerging markets were then the dominant global economies. So the picture of the emerging world rising in economic importance is a very long-term trend, and the issues which affect markets daily – whether inflation in China has peaked or whether the Brazilian currency is overpriced – are short-term issues which should not weaken the big picture of a more balanced world.
Returning to normal – how the balance is shifting back towards a long-term trend
Source: Paul Bairoch, “International Industrialization Levels from 1750-1890” Journal of European Economic History; Samuel P. Huntington, “The clash of civilizations and the remaking of world order; Manufacturing Value added from International Yearbook, United Nation Statistical database.
While this reversion is interesting, what’s important for investors, however, is how much companies are earning and whether they are attractively valued or not.
As emerging market equities have fallen but company earnings (income) and asset values have risen, emerging market companies now appear to be attractively valued. Of course, one must always be mindful of the risks – for example, equities don’t trade as cheaply when everyone is positive and optimistic. There are even many conflicting views over whether buying into equities right now is a good idea.
Company earnings are key for the next year
While valuations may be attractive, the key to whether emerging market equities will perform well over the next 12 months, in our view is ultimately the direction of company earnings. Clearly, the price of emerging market equities closely shadows what happens in the developed world. In order to get a more accurate picture of whether a company has good potential, one of the key factors to consider is what earnings a company will produce.
There are a range of outcomes that investors are expecting. We are predicting a base case scenario which is emerging market earnings growth in 2012 in the 10-12% range. Some investors are more optimistic (up to 25% growth), some less so, with the worst case scenario – seen in previous crises – being an earnings drop of between 20-30%.
We are certainly not expecting an emerging market crisis in 2012 (a downgrade of earnings forecasts at worst) because fundamentally these nations are so much stronger than in previous crises. Compared to the developed world, emerging markets have low levels of debt and subsequently have large cash reserves to deploy. These reserves can be used to boost government spending to maintain economic growth during difficult conditions – an option that is dwindling for governments in the cash-strapped developed world.
This fundamental fiscal strength, combined with durable company profits, attractive valuations and rising domestic growth and consumption help consolidate the long-term case for emerging markets, even as world markets are disrupted by uncertainty.