Want growth? Look to emerging markets

Data show that emerging markets have outperformed their developed counterparts in the past five- and 10-year periods

The conventional view that clients who are focused on long-term growth should choose developed markets over emerging markets if they are to obtain the best returns does not hold true if you look at the average returns of these markets over the past five- and 10-year periods.

In fact, over the past decade, growth investors would have been better off if they had pumped more money into emerging markets. Traditionally considered riskier and more volatile, emerging markets have, on average, substantially outperformed their developed counterparts over the five- and 10-year periods ended Oct. 15 in U.S.-dollar terms.

But whether clients should increase their exposure to emerging markets is a question not only of clients’ time horizons but also of their willingness to trade off increased volatility and risk for greater long-term returns.

Generally, clients should not hold more than 30% of their portfolios in foreign markets, says Phillip Armstrong, CEO of Jovian Capital Corp. in Toronto and a proponent of long-term investing. That said, he believes investors looking for growth should increase their exposure to emerging markets. “Volatility,” he says, “should not be equated with risk.”

Based on the regional performance of the MSCI price index, the best-performing index, in US$ terms, for the five years ended Oct. 15 was the MSCI emerging-markets Latin American index, which has an average annual return of 17.3%; for 10 years, the MSCI EM Eastern Europe index, which gained 15.3% annually, was tops.

Comparatively, the best-performing developed-markets index in the five-year period was the MSCI EAFE index, up a meagre 2.1% annually; for the 10-year period, it was the MSCI Pacific index, which had an average annual return of 2.2%. Meanwhile, the blue-chip MSCI North American index declined by 2.1% a year on average in the five years and 1.1% in the 10-year period.

Arguably, the fallout from the global credit crunch, which sent developed markets into a tailspin in recent months, has resulted in the developed markets’ poor long-term performance. But emerging markets have lost even more ground amid the chaos. For instance, the MSCI (developed) world index is down by 40.2% year-to-date, while the MSCI EM (universe) index dropped by 49.96% during the same period.

Yet, emerging markets remain ahead over the long term. The EM index reported average annual gains of 8.9% in the five years and 9% in the 10-year period, compared with losses for the world index in those same periods.

“Emerging markets are certainly more attractive over the long term,” says Chuk Wong, vice president and portfolio manager with Goodman & Co. Investment Counsel Ltd. in Toronto. However, he cautions, emerging-markets investors must be able to stomach the greater volatility that is typical of these markets.

Emerging markets as a whole represent the second-largest economic bloc in the world, behind the U.S. Yet, says Wong, they are under-represented in major global stock market indices: “There is scope for greater exposure.”

Bob Gorman, vice president and chief portfolio strategist with TD Waterhouse Canada Inc. in Toronto, agrees: “There is no question that emerging markets, as a percentage of global gross domestic products, are rising.”

Gorman is not averse to increased exposure to emerging markets, but, like Wong, he advises clients that they must be able to tolerate the emerging markets’ “notorious volatility.”

On the other hand, clients can obtain indirect exposure to these markets, he adds, by investing in developed-market companies that benefit from emerging-markets growth.

Brent Smith, chief investment officer for Calgary-based Franklin Templeton Managed Solutions, a division of Toronto-based Franklin Templeton Investments Corp., says emerging markets are generally characterized by higher growth rates than developed markets and, consequently, can provide better returns. He, too, maintains that emerging-markets investors must have a long-term investment horizon and a higher tolerance for risk if they are to benefit from emerging markets’ potentially greater returns.

The scope for emerging markets remains bright, Smith adds. GDP growth is largely internally driven and is not overly dependent on external factors; middle-class influence is driving their economies and their populations are relatively young. In addition, their banking systems, especially those in Asia, are better than the ones in the developed world in many instances. And strong infrastructure development in some markets, including the Middle East, is a catalyst for growth.

“The risk premium of emerging markets,” Smith adds, “will gradually shrink.”

Although the correlation between emerging and developed markets has apparently increased, Smith contends, negative sentiments toward emerging markets is greater than warranted in the current crisis, given their relatively sound fundamentals. (See page 26.)

Wong claims that the blurring of lines between emerging and developed markets is largely responsible for the greater slump in the relatively riskier emerging markets.

Mark Grammer, vice president of investments with Mackenzie Financial Corp. in Toronto, argues that emerging markets might have fared better if only the U.S. was affected by the global credit crunch. However, the fallout in other areas — Europe and Japan, for example — resulted in “a co-ordinated global slowdown in developed markets, which affected emerging markets.”

As such, emerging markets remain favourable from a risk/reward standpoint, Grammer says. Their growth rates, on average, will be higher that those of developed markets, even in a slowdown.

“Emerging markets,” he says, “are probably the only place in the world in which you will have positive growth for the rest of 2008 and the first half of 2009.”

But the consensus is that neither developed nor emerging markets will experience a big recovery in the near term. Irwin Michael, president of Toronto-based I.A. Michael Investment Counsel Ltd., says clients must first regain confidence in the markets: “Currently, stock prices have no bearing on valuations; everything is liquidity-driven.”

With valuations at relatively low levels, Michael sees significant buying opportunities. A deep-value stock-picker, he believes opportunities exist in companies with good balance sheets, tangible book values and the “wherewithal to make it happen in this difficult period.”

Looking ahead, Gorman expects continued volatility in the near term, before the markets — both developed and emerging — head higher.

Both Wong and Grammer see growth plays in emerging markets. Grammer argues that even though growth is slowing in China, for example, it will slow to about 8% annually, which is still very strong.

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