Emerging markets: Non-Asian economies to grow

15 Jan, 2010 by Dwarka Lakhan

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Rising demand for natural resources and consumer goods will fuel expansion

One investment sec-tor that holds much promise for 2010 is emerging markets. While the outlook for some of the world’s largest economies, such as the U.S., Japan and Germany, remains clouded, less developed nations are well positioned for growth. The economies of some countries in Latin America, eastern Europe, the Middle East and Africa performed relatively well in 2009 and are expected to continue recovering in 2010.

Expansion in these countries is being fuelled by global demand for natural resources, as well as by consumer-oriented domestic industries such as wireless. But forecasters warn that performance will vary widely among countries and sectors, requiring close attention to specific investing decisions.

Indeed, emerging economies have displayed “remarkable resilience” in the wake of the recent global financial crisis, according to the International Monetary Fund. In its October 2009 World Economic Report, the IMF projects that Latin America will grow by 3% in 2010, vs -2.7% in 2009.

Other regions with positive outlooks, according to the IMF, include: the Middle East, expected to grow by 4.2% vs 2% in 2009; Africa, up by 4%, from a respectable 1.7% in 2009; and emerging Europe, up by 1.8%, vs -5.2% last year.

Some of the optimism about the strength of non-Asian emerging countries is the flip side to the declining expectations for the still beleaguered U.S. consumer.

“China has replaced the U.S. in trade,” observes Timothy Morris, emerging markets portfolio manager with J.P. Morgan Investment Management Inc. in New York. China is now the world’s largest importer of metals and minerals, which dominate the exports of many emerging nations.

Caution, however, is required. “You have to look at each area individually,” says Mark Mobius, executive chairman of Templeton Asset Management Ltd. in Singapore and lead manager for Templeton Emerging Markets Fund and Templeton BRIC Corporate Class.

Among Latin American countries, only Mexico is closely tied to the U.S. economy. Brazil’s trade in iron ore and other minerals is with Europe and Asia, while Chile will benefit from strong demand in China for copper.

Bob Gorman, vice president and chief portfolio strategist with TD Waterhouse Canada Inc. in Toronto, notes that 41% of all Latin American exports are destined for the U.S. But dependence on the U.S. market varies widely among these countries. Only 16% of Brazil’s exports and 12% of Chile’s go to the U.S., compared with 80% of Mexico’s exports.

Still, Morris says, Mexico is much more resilient than that figure would suggest. He argues that although Mexico is typically viewed as having the strongest link to the U.S. among non-Asian emerging countries, “the link is not necessarily in trade but more in remittances.”

In Africa, the demand for minerals will continue to recover, benefiting South Africa. Nigeria sells its oil and gas around the world, as does the Middle East. Oil producers will benefit from the bounce-back in oil prices that is being driven by quick and strong recoveries in China and other Asian emerging markets.

The laggard among non-Asian emerging markets this year will be eastern Europe, contends Gorman, even though it “has limited direct exposure to the U.S.”

On the positive side for investors, a lot of the countries in eastern Europe serve as low-cost manufacturing hubs that supply goods to western Europe, which is also expected to have only moderate growth this year. For instance, Gorman says, “70% of the GDP of the Czech Republic and 67% of Slovakia’s is based on exports of cars to Western Europe.”

In addition, Gorman notes, eastern Europe “has been severely constrained by high debt levels.”

But the debt issue is far from a common problem. Arguably, many emerging countries were in a relatively strong fiscal position when the financial downturn began, due to prudent policies, and are well positioned for a rebound. They “have had a strong windfall from high commodity prices and were conservative about how they spent their money,” says Morris. As a result, these countries entered the financial crisis with larger foreign exchange reserves, lower debt ratios and better GDP growth than their developed counterparts.

Still, many emerging markets remain linked to the health of countries that were overleveraged in North America and western Europe. “Their growth cannot be separated from developed markets, in terms of trade and capital flows,” says Mobius. But, he adds, it is evident that as time goes by, emerging markets are becoming less dependent on trade with the U.S. In addition, domestic growth within non-Asian emerging markets is also stimulating internal demand, which is “picking up dramatically, boosted by [government] subsidies,” he says.

Rising demand for natural resources and consumer goods will fuel expansion

Growth in emerging markets is also being driven by powerful demographic factors. Populations that are younger and more mobile than in the developed world are creating higher rates of consumption and household formation. As well, there has been a continuing trend toward relocating populations from rural to urban areas. That is especially true in manufacturing-intensive countries, such as Brazil and Mexico, says Morris. This shift “creates additional consumers, increases per capita incomes and bolsters domestic spending,” he says, adding this is accompanied by substantial infrastructure spending in some countries.

While many non-Asian emerging countries can’t afford large stimulus packages, Gorman notes, Brazil’s stimulus package amounted to 8.7% of its GDP last year, which is very substantial. He adds: “Increased government spending is universally true across Latin America.”

Morris says Russia was equally aggressive in allocating significant sums from its reserves to control currency deflation.

Heading into 2010, Morris expects that emerging markets will move into an “earnings growth phase” and he anticipates an average “27% rebound in earnings.” He is taking a stock-specific approach to investing and says that “earnings rather than valuations” would be his main decision driver.

Among the sectors that Morris favours are consumer goods, domestic telecommunications and certain areas related to infrastructure spending, such as cement manufacturers and producers, and localized industries. He is underweighted in the oil sector, as he believes “there is no visibility in predicting the price of oil.” In terms of specific non-Asian countries, Morris is overweighted in Brazil; he likes airlines and domestic consumption-driven plays in Turkey; and financial services in Nigeria.

Gorman will be focusing more on sectors such as financials, consumer stocks and energy; he believes that prices for metals and minerals “have already risen a lot.” Among his fund holdings are Itau Unibanco SA, Brazil’s largest bank, which is exposed to a rapidly growing economy; Petroleo Brasiliero SA, a large Brazilian oil company with substantial offshore discoveries; and America Movil SAB, a large wireless company with 70% of the market in Mexico and significant room for growth.

Mobius favours consumer products that will be a beneficiary of rising per capita income in non-Asian markets, which is increasing at a faster rate than in developing countries. He also likes commodities — their prices, he says, “will trend upwards over the long term, driven by greater demand and a weaker U.S. dollar.”

There are some issues to be aware of when it comes to emerging markets. Typically, currency swings can have a significant impact on the returns of foreign investors in these regions. With only a few exceptions, there is almost a universal trend toward appreciation of emerging markets’ currencies against the US$ — and many analysts expect this to continue. However, Gorman does not anticipate “that movements of the US$ [against these currencies] will be sufficiently great” to have an impact for Canadian investors.

Although inflationary or deflationary threats can derail the growth prospects for non-Asian markets, Morris has “no significant concern about either inflation or deflation.”

Mobius, on the other hand, is “keeping a close eye on inflation and interest rates,” although he does not anticipate any significant changes.

Should inflation materialize, Gorman proposes a more pronounced portfolio shift into “inflation hedgers” such as commodities. Conversely, if deflation materializes, he will move into stocks in which “you have pricing power,” such as banking and mobile telephone companies.

For now, says Morris, “there are no major risks on the immediate horizon” in non-Asian emerging markets. He says that the fallout from real estate speculation in Dubai is still to come but he doesn’t expect this to affect other emerging markets significantly. But he also notes that the recent Brazilian proposal to restrict foreign investment in order to control capital inflows and prevent overheating could negatively affect foreign investors.

On balance, predicts Gorman, non-Asian emerging markets “will go up for a second consecutive year.”

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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