Emerging markets set to improve

Despite a subdued outlook, portfolio managers predict emerging markets will show improvement over last year. The challenge will be in picking stocks and sectors rather than country plays. A growing middle class remains a driving force

The outlook for emerging markets (excluding Asia) is relatively subdued heading into 2014. But fund portfolio managers expect these markets to perform better this year than they did in 2013.

“The investment environment will be more encouraging,” says Matthew Strauss, vice president, emerging markets and foreign exchange strategy, and portfolio manager with CI Investments Inc. in Toronto. “With few exceptions, there would be a slight improvement in economic growth.”

The International Monetary Fund’s October forecast has Latin America’s growth at 3.1% this year vs 2013’s 2.7%; Central and Eastern Europe, 2.7% in 2014 vs 2.3%; the Middle East and North Africa, 3.8% vs 2.1%; and sub-Saharan Africa, 6% vs 5%.

“It will be a stock-pickers market over the next 18 months or so,” says David Kunselman, senior portfolio manager with Excel Investment Counsel Inc. in Mississauga, Ont.

Serge Pépin, vice president, investment strategy, with BMO Global Asset Management Inc. in Toronto, agrees: “We will be looking at companies that demonstrate growing free cash flows and dividend streams as a result of strong business models.”

Growth in consumer spending will remain the central investment theme across most emerging markets. But increasing demand for health care, greater use of financial products and services such as credit products, and the rise in infrastructural spending will also be on portfolio managers’ radar screens.

“The growing middle class in many developing countries is here to stay,” Pépin says. This trend, he adds, will be the impetus for increasing urbanization, infrastructure development and higher demand for discretionary and non-discretionary goods.

Portfolio managers also will be paying attention to the impact of tapering of the U.S. Federal Reserve Board’s monetary stimulus program, scheduled to start this month, says Jeff Feng, vice president and portfolio manager with Invesco Canada Ltd. in Toronto. When the Fed first proposed tapering last May, emerging markets (especially those with large current-account deficits) experienced sell-offs on fears of higher interest rates.

But, Feng contends, the effect this time around will not be as dramatic because emerging markets have had time to prepare.

There also is the impact of stronger growth in the industrialized world, which Strauss thinks will fuel demand for more exports from emerging markets, particularly in Eastern Europe.

However, Feng warns, with high unemployment rates in developed Europe, there is less political incentive to relocate capital to countries such as Poland and Czech Republic because of the need for jobs at home.

Latin America. The end – for now – of rising commodity prices has affected several countries, especially Brazil and Chile. However, Pépin feels most of region’s economies “are on a sound footing, with healthy balance sheets, low unemployment and solid macro frameworks in place.” Kunselman, however, cautions that inflationary pressure will remain “stubborn.”

With Brazil facing a credit rating downgrade and an election this year, Mexico has emerged as the most favoured country in the region. Stronger growth in the U.S. and a reform agenda that includes the energy, telecommunications, education and financial services sectors bode well for Mexico, says Strauss. Infrastructure spending will benefit construction companies and the financial services sector, including banks – although, he warns, financial stocks are currently expensive.

Pépin and Feng also like the financial services sector; Feng favours banks, credit card companies and transaction processing companies in particular, along with the consumer sectors.

Eastern Europe, Turkey and Russia. In Eastern Europe, Strauss favours consumer companies, banks and exporters to developed Europe. Countries such as Hungary, Poland and, to a lesser extent, the Czech Republic will benefit from a modest economic recovery in developed Europe. Feng sees opportunity in certain grocery, retail and bank stocks.

Turkey remains vulnerable, Strauss says, due to high inflation and currency pressures resulting from its high current-account deficit and “reliance on hot money.” But Pépin, on the other hand, says: “Turkey remains an attractive long-term market, given its rapidly growing population, which will increase domestic consumption.” This will benefit consumer-related companies.

Pépin remains cautious about the investment prospects of Russia. Economic growth remains weak, corporate governance is disappointing and there are few appealing investment opportunities outside of the energy and resources sectors. Feng is wary of Russia’s big energy companies, but sees opportunity in Russia’s Internet.

South Africa. Strauss believes domestic consumer companies and industrials, which have exposure to the African continent, will do well. Feng likes mining equipment and consumer related firms.

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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