Managers take country-and sector-specific approach

Global growth, increased liquidity, greater consumer confidence will combine to make emerging markets more attractive

Analysts are optimistic about the prospects of non-Asian emerging markets this year. Improving liquidity, continuing global growth, rising commodity prices, reasonable valuations and subdued fears of higher U.S. interest rates should all combine to make Latin America, Eastern Europe, the Middle East and Africa relatively attractive.

While the outlook for non-Asian emerging markets as a whole is positive, investment managers are selective in favouring specific sectors in certain countries, such as telecommunications and technology in Brazil, Mexico and Israel; the consumer sectors in Mexico and South Africa; commodity stocks in Brazil, Mexico and South Africa; and banking in Turkey.

Increased liquidity will be fuelled largely by institutional money managers, who are expected to pump more cash into emerging markets. Many of these managers are beginning to use the popular MSCI All Country World Free ex-U.S. Index (ACWI) as their benchmark. Emerging markets currently account for a cumulative weight of 9.15% on the ACWI, with non-Asian emerging markets accounting for more than half of that 9.15%, making it tough for investment managers to exclude them from their portfolios. Use of the ACWI facilitates direct global comparisons and makes what was known as ’emerging market investing’ a part of ‘international investing

Emerging markets should also be a direct beneficiary of continuing strength in the global economy, which has been accompanied by higher demand for primary commodities. Cyclical, resource-based commodities account for a significant portion of gross domestic product in most Latin American and African countries.

As well, these countries are poised to benefit from rising consumer confidence and strong growth in their telecommunications and technology sectors, which are direct beneficiaries of higher foreign investment.

Fears of higher U.S. interest rates, which weighed on emerging markets for much of last year, have abated following three rate increases by the U.S. Federal Reserve Board during 1999. Although economists forecast another 50-basis-point increase in the first half of this year to stem inflationary pressures in the surging U.S. economy, it’s not expected to be enough to dampen sentiments toward emerging markets. Even with these increases, interest rates remain relatively low, keeping down borrowing costs. Some markets are discounting the anticipated rate increase already.

Given the positive outlook for these markets, it is important that your clients maintain and/or increase their exposure to non-Asian emerging market mutual funds. Canadians on average hold less than 1% of total mutual fund assets in non-Asian funds. Despite the fact that these markets are somewhat riskier, your clients can benefit from potentially strong returns with little downside risk because of limited exposure.

The case for Latin equities is a re-rating story based on lower discount rates as sovereign risk declines,’ says Mary Curtis, global emerging market strategist for Warburg Dillon Read in London, Eng. ‘Earnings growth is reasonable but unspectacular, given moderate growth in real GDP next year. Debt and equity markets are pricing in significant risk relative to history and appear to have attractive valuations.’

Vincent Fernandez, lead manager of the Altamira Global Discovery Fund and co-manager of the Altamira Global Diversified Fund for Altamira Investment Services Inc. in Toronto, plans to take a ‘sector-specific, rather than a country or regional approach’ to emerging markets this year.

He likes telecommunications and paper stocks in Brazil, and telecommunications and consumer staples in Mexico. Telecom stocks are benefiting from greater use and convergence of phone, cable and Internet firms.

Paper companies in emerging markets are good investments because lower wages give them a competitive advantage over their developed market counterparts. ‘In Mexico, inflation is expected to fall and real income growth rise in 2000, benefiting the consumer sector,’ Fernandez says.

Countries such as Mexico and South Africa are also benefiting from higher oil and gold prices, respectively.

In emerging Europe, Middle East and Africa, Curtis believes ‘domestic recovery is underway across the region, diverse as it may be. Greece is the exception to this general outlook only because we forecast strong growth to continue higher. For the region as a whole, however, we forecast GDP growth to recover to 3.1% in 2000 from 1.1% in 1999. This is driven by rising real GDP across all countries, although the largest turnaround stories are in the Czech Republic, Turkey, Russia and South Africa.’

Fernandez is again selective in his approach to this part of the world and plans to maintain exposure to telecom equipment and software companies in Israel, selected banks in Turkey, and consumer products, banks and commodity stocks in South Africa.

‘Israel has some world-class technology companies, while Turkey will benefit from legislative changes to social security and banking systems,’ Fernandez says. ‘South Africa is experiencing a stable currency, lower interest rates and stronger commodity prices.’

There are risks to emerging markets. Russia’s rebound is expected to continue, but Fernandez considers that market unpredictable.

The domino effect of a fallout in the U.S. market may be the biggest threat to emerging markets. If the U.S. stock market falls or the U.S. dollar tumbles, money would flow out of the stock markets, requiring higher interest rates to finance the U.S. current account. Higher than expected U.S. inflation could push rates higher, to the detriment of non-Asian emerging markets.

Emerging markets have survived the fallout in Asia, the Russian ruble crisis and devaluation of the Brazilian real. But improving governance, better fiscal and monetary policies, more accountability, and legal and legislative changes make a rebound likely in 2000.

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.

More articles by Dwarka Lakhan