Why emerging economies are proving world-beaters

Fueled by myriad internal and external factors, emerging economies have been on a roll over the past five years — significantly outperforming their developed counterparts. While they remain vulnerable to external shocks, their prospects remain good for the near future, presenting investors with an abundance of opportunities to benefit from their growth.

Growth has been impressive. Spreading investments over several countries may be best way to mitigate risks, analysts say.

Based on the returns of the Morgan Stanley Capital International indices, emerging stock markets have on average outperformed all developed markets over the one-, three- and five-year periods ending Feb. 28, in Canadian dollar terms, with the exception of the S&P/TSX composite Index over the five-year period. The Canadian index was the second best performer, followed by MSCI Europe, while the S&P 500 was the worst (see table).

“Strong economic growth has been a big factor in the strength of emerging markets,” says Mark Grammer, vice president, investment for Mackenzie Financial Corp. in Toronto. “Overall, average GDP growth in emerging markets has been about 3% greater than in developed markets.”

In fact, since 2000 emerging markets have grown about two-and-a-half times as quickly as the developed world, averaging over 6% a year. The International Monetary Fund forecasts that strong growth will continue in 2005, albeit somewhat slower.

“Growth has been relatively consistent across all emerging regions,” says Chuck Bastyr, managing director and portfolio manager of BPI Global Asset Management LLP in Toronto. “It has not been a case of one region stumbling and another taking off.”

Bastyr adds that emerging markets have been in a catch-up mode over the past four to five years following a slump in the late 1990s in the wake of the Asian crisis.
“Stocks became cheap after individual investors left but have picked up again, with local investors getting back into the fray.”

Capital infusion

As a result of their growth, “emerging markets have attracted significant investment flows, both in terms of foreign direct investment and portfolio investment,” says Grammer. According to the Washington, D.C.-based Institute of International Finance, emerging economies received US$279 billion in private capital in 2004, up 32% over 2003, and the highest level since 1997. The IIF forecasts that US$275.8 billion will flow into emerging markets in 2005, with the Asia/Pacific region receiving 45.5% of the amount, Europe 36.7%, Latin America 14.3% and Africa/Middle East 3.5%.

Growth has been fuelled by high commodity prices, improved exports and low global interest rates, which in turn have contributed to improved financial health. “Many emerging markets such as Russia, Peru, Brazil and Indonesia are resource rich and have benefited from higher commodity prices which are at 20-year peaks,” says Bastyr. “Chinese demand has largely fuelled commodity exports.”

On the other hand, many Eastern European countries have benefited from expansion of the European Union and the potential for further expansion.

“These countries have experienced substantial investments in infrastructure and have been stimulating growth through policy measures as they prepare for inclusion in the European Union,” says Grammer.

Emerging Europe has also seen dramatic political change — from communism to capitalism and convergence among the regional economies, says Bastyr. “A lot of capital is being freed up, labour costs are low creating outsourcing opportunities from industrialized European countries, a flat tax is in place and assets are being reflated resulting in higher property values.”

On the whole, the financial health of emerging economies has also improved, making them more attractive. “They are on average running current account surpluses, reduced deficits, and lower debt-service costs,” says Bastyr. Demographic factors — a younger, more mobile population — are also a driving force, supporting higher consumption and household formation; expansion is being financed to a significant extent by domestic savings; and currencies are undervalued, facilitating cheaper exports.

Positive developments have influenced investors to “attribute a lower risk premium to emerging markets” says Grammer. “Yet investors may still have events such as the Asian contagion and the Argentine crisis on their minds which cause them to second-guess their decisions.”

However, a research paper, “Emerging markets aren’t as risky as you think,” published by Marc Goedhart and Peter Haden in the Spring 2003 issue of the The McKinsey Quarterly journal says that “actual risks in emerging markets may often be smaller than commonly assumed, at least for those corporations and shareholders that employ a portfolio approach to investing there … In fact, systematic measurements of risk find emerging-market indexes to be, on the whole, less risky than a world portfolio over the past 15 years.”

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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