There are several key drivers behind the positive performance of emerging market equities.
Stronger economic growth – While the emerging equity markets account for just over 10% of world stock market capitalization, data from the World Bank and The Economist indicate that the combined gross domestic product (GDP) of emerging economies now accounts for more than half of the world GDP using purchasingpower parity (or approximately 30% based on market exchange rates). Emerging economies are forecast to grow by 6.9% during 2008, according to the International Monetary Fund’s January 2008 World Economic Outlook, compared to 4.1% growth in developed markets.
Change in supply/demand balance – As emerging economies grow, they consume more goods and produce more raw materials. This balance will shift where the goods and raw materials are produced, affecting the relative growth potential of emerging and developed markets.
Transition to developed market status – The political and financial backgrounds of China and India are stronger and more stable now than in the past, so it’s possible that these countries will transition to developed economy status more quickly.
What Could Go Wrong?
While memories of the last Asian crisis or Russian debt default may have faded, emerging markets have generally shown considerable volatility and have been vulnerable to contagion. Their future will depend on whether or not the recent strength represents overstretched valuations. In markets such as China, investment managers are seeing signs that valuations in some sectors are expensive, but they do not believe that high valuations have been reached in all emerging markets.
Growth in emerging economies is increasingly being generated through domestic demand and trade between emerging economies, rather than through exports to developed markets—a positive sign that these markets have been able to separate themselves from developed markets. Continuing strong liquidity flows may depend on how emerging markets are affected by a recession or slowdown in the U.S. It will be a real test over the course of 2008 to see if they have truly decoupled from the world’s largest economy.
Getting In on the Action
Pension plan investors can access emerging markets through global or international equity managers, emerging equity specialist managers, or a combination of both types. Global or international managers must be able to select good stocks in emerging economies rather than just have an exposure. The attraction of this approach is that the manager determines whether to overweight or underweight emerging markets, depending on the outlook, and can choose companies from within a larger universe.
Plan sponsors seeking to maximize returns from emerging markets should also consider specialist managers. If only global or international managers are selected, the pension fund’s total exposure to emerging markets likely won’t be sufficient.
Based on demographics, GDP growth and the maturing of stock markets, emerging markets provide good medium- to long-term growth potential. Although there are risks, Canadian pension investors should review their strategies for investing in emerging markets—and if they decide to increase allocations, they should make this move gradually over time, given the strong recent performance and the more volatile shortterm characteristics of these markets.
Peter Muldowney is Mercer’s investment consulting Canadian business leader, and Debbie Clarke is a manager researcher based in London, England. peter.muldowney@mercer.com; deb.clarke@mercer.com
For a PDF version of this article, click here.
