Guide to Global Investing: Part 1

After cumulative performance advanced more than 400% in the preceding five years, the MSCI Emerging Markets Index declined more than 50% in 2008 amid the worst financial crisis since the Depression. Although the asset class has rebounded sharply year-to-date, there is growing concern that these gains have outpaced reality, prompting the question, Is this sustainable? While it’s reasonable to worry about the next abrupt downturn in emerging markets equities, we believe there is cause for optimism.

Evolution in Fundamentals
Today’s emerging markets are very different from prior periods, thanks to transformational structural reforms and better macroeconomic policies. Notwithstanding the currency devaluations, debt defaults, runaway inflation and other woes that battered emerging markets in the 1990s, many countries have overhauled their economies, resulting in surpluses rather than deficits (Figure 1), significant foreign exchange reserves and investment-grade credit ratings, as well as more effective central bank policies. Likewise, many emerging markets companies have improved their balance sheets, corporate governance and the quality of their management, fostering a more stable investment environment.

For much of the past decade, gross domestic product (GDP) growth for emerging markets has outpaced the developed world by a margin of 4% to 5% (Figure 2). Although growth fell off sharply virtually everywhere in 2008, emerging markets have still grown faster than their developed market counterparts. Recent forecasts suggest that average growth in emerging markets will likely drop to less than 4% this year. This is weak compared with the recent past, but still robust compared with an expected 2% decline in the GDP of the G7 economies.

A sustained level of economic growth has historically translated to growing per capita income and rising domestic consumption—most notably in emerging countries such as China and Brazil. The macroeconomic changes responsible for the fundamental improvements in these economies should help them to weather short-term economic setbacks without triggering widespread declines.

Population rankings of major world regions continue to shift in favour of developing regions. By country, China was the most populous nation in 2002, followed by India, the U.S., Indonesia and Brazil. In fact, Asia/Oceania has held half of the world’s population since 1950 and is expected to continue to do so through 2050. Furthermore, the less developed countries in Asia/Oceania are expected to be more populous than any other region by 2050.

As witnessed in China, India and other emerging economies, such population booms often result in a population shift toward urban centres, implying huge infrastructure spending for housing, power generation, transportation and other ancillary services associated with expanding cities. While each region is in a different stage of evolution, we believe that rising urban populations, increased output and fast-rising incomes bode well for continued economic growth in the developing world.

Growth in Market Cap
Emerging markets now account for about 80% of the world’s population and almost half of its economic output. Their share of the world’s stock market capitalization is also growing (Figure 3). Having doubled in size over the last decade to approximately 10% of world market cap, the asset class is, in our view, too big to ignore. There are several ways for investors to participate in the growth potential of emerging markets, such as investing in global companies, international equity or dedicated emerging markets strategies and—depending on their risk tolerance—regional- or country-specific strategies.

We remain positive about the long-term prospects of the emerging markets asset class. During the recent crisis, emerging markets have proved less vulnerable to global economic turmoil—thanks, in part, to lower debt burdens, higher reserves, strengthened domestic institutions and lower inflation.

While the risk of investing in emerging markets is lower today than in the past, it is still much higher than in developed markets, and investors should expect significant price volatility. Presently, a number of short-term risks require monitoring, including potential headwinds in the form of a more prolonged economic contraction in the developed world. Politics could also derail performance, as more than a dozen developing countries will hold key elections over the next 18 months. Terrorism, protectionism and rising commodity prices can also adversely affect developing economies.
However, we believe that emerging markets equities can be an important strategic component of a diversified portfolio for many long-term investors.

Brent Jones is senior vice-president and portfolio manager, emerging markets equities, with GE Asset Management.

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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the July 2009 edition of BENEFITS CANADA magazine.