Emerging markets ideal for strategic allocation

Emerging market equities remain one of the best sectors for long-term performance, says a global investment strategist for one of the world largest institutional investment firms. Possibly even more important for investors, the volatile nature of the asset class is expected to decrease over the long term.

George Hoguet, managing director and global investment strategist specializing in emerging markets for Boston-based State Street Global Advisors (SSgA), was in Toronto on Thursday, giving pension managers and consultants an overview of the emerging markets. He says that despite the phenomenal returns and decreasing volatility in emerging markets, many managers are still shy about investing in them.

Hoguet suggests that investors of all stripes create a global asset allocation benchmark and invest strategically — buy and hold — in emerging markets, taking a top-down view.

“Emerging market equities can almost be viewed as a call option on world growth,” he says. “What we really have to think about is what the world looks like while we are moving forward; there are some secular drivers. First of all, China’s economy is now larger than Germany. Twelve years from now, it’s expected to be larger than Japan, and if you look at a straight line projection, by 2045 China is larger than the United States.”

There are other fundamental factors that position emerging economies for long-term sustained growth, including younger demographics to fuel innovation and labour supply and — for the two most high-profile emerging economies, China and India — relatively low dependence on the U.S. and other Western economies.

“What drives equity prices in the long term are real earnings per share growth net of issuance, and real earnings per share growth tracks long-term GDP growth,” he says.

In the intermediate term, emerging economies are growing more rapidly, and therefore earnings per share are growing more rapidly, Hoguet says. Many investors likely realize this, but risk has been a deterrent — something Hoguet doesn’t dispute.

He says there is concern by market observers that emerging market economies may stall under the weight of higher commodity prices, similar to the North American market in the 1970s.

“Since the inception of the emerging market equity index in 1988, emerging markets have substantially outperformed Canadian equities — particularly over the past five years,” he says. “There is the prospect of slowing productivity growth. If you look from 1969 to 1982, the Dow Jones did nothing; it was essentially flat. Are we going back to this period of stagflation? What accompanied the oil shock of the 1970s was a significant drop of productivity, not just in the United States but in Europe and Japan. That seems to be the real question for investors [in emerging markets].”

For some emerging markets, like Brazil, the commodity boom will be a boon; for others, like China, it could dampen growth.

There is also the question of whether a sagging U.S. economy will take a bite out of earnings. In both circumstances, Hoguet expects slower growth for countries like China in the near term, but eventually — like the North American economies did in the 1980s — he expects them to adapt.

“I think that supply and commodities will become unstreamed, but it can take many years to do that. Look at the price of oil in the 1970s. Oil in real terms peaked in the late 1970s, but in the 1980s the industry laid off people by the thousands because new supply came online,” he says. “The same thing is going to happen in terms of new product for things like copper, tungsten, etc. That’s probably going to take about five to seven years to happen. If there is a sharp drop-off of commodities, China will be a winner and Brazil will be a loser. If it’s associated with a global recession, emerging markets in general will be very negatively impacted.”

Emerging economies in Asia do have some significant external risk protection in that they have largely decoupled from U.S. demand. It’s domestic growth that’s fuelling their rise.

“The largest economies in Asia are actually amongst the least sensitive to growth in the United States. I want to suggest that the laws of domestic demand and consumption in emerging markets in Asia will see them through this period,” he says.

“There will be a slowdown in growth over the next while, probably in the neighbourhood of 50 to 100 basis points. Just to give you an idea of the extent of China’s domestic demand, it installed the electricity generation capacity of the United Kingdom last year alone.”

It’s the decoupling that makes emerging markets a necessary asset class for diversification since their returns will be somewhat uncorrelated to those of developed markets. Hoguet warns that emerging markets can’t be viewed in one broad sweep. The best way to invest is to examine each sector and company on a case-by-case basis.

“The reasons for investing in emerging markets are really diversification and a growing investment opportunity set,” he says.

He also notes the credit risk particularly on larger companies based in emerging equities is actually being upgraded during a period in which global equities are being downgraded. While this is good news for investors in those companies, it can make index investing in those regions problematic for investors opting to get their exposure to emerging markets through exchange traded funds that track benchmarks like the MCSI Emerging Market Index.

While index companies have gotten better at selection criteria, he says, they can still lead to misleading classifications.

“MCSI is rebalancing to consider putting Israel and Korea into developing markets. They are thinking of demoting to the frontier class Colombia because of capital controls, as well as Pakistan. They are thinking of taking the Gulf Cooperation Council markets that are awash with [oil] cash and taking them out of frontier and into emerging markets,” he says. “From an investor’s standpoint, what we own is more important than the way we classify it. The structural characteristics of the Korean market haven’t changed just because the MCSI classifies it as one market and changes it to another.”

Hoguet explains that many of Korea’s characteristics remain on par with those of emerging markets. They have very serious political and security threats and relatively weak financial institutions. Therefore, he wouldn’t want to give it the same risk characteristics as developed markets. Even in developed markets, institutional weakness in the ratings agencies was partly responsible for the sub-prime crisis. These risks are magnified in emerging markets.

“What really defines an emerging market is not so much payout of income but the strength of its institutions. I think that a benchmark provider needs to take into account those factors,” he says. “Indexes have enormous and, I think, disproportionate influence in terms of the flows of global capital. What are people structurally underweighting? If Korea migrates from emerging markets to developed status, that means there’s going to be a net inflow into Korea.”

He adds, “I actually think the freeze-up in liquidity that we’ve seen, for example, in the mortgage market could happen in the emerging markets. We’ve seen tremendous push factors leading to trend following, leading to flows into emerging markets. We could see a situation where the global environment is dramatically incapable of continuing this.”

Still, for retail investors increasing their portfolio allocation to emerging markets, Hoguet says, indexes are probably the way to go. It’s simply too costly for them to try to emulate a good institutional portfolio that has the resources to do specific equity and sector analysis. He stresses that investors should still take a hard look at valuations of equities from those regions.

“For a retail investor, ETFs offer a very good opportunity. SSgA actually has regional ETFs and single country ETFs as well. Depending on one’s view of certain countries, you can construct a certain view,” he says. “Most of the growth in emerging markets is going to come from earnings; it’s not going to come from price-to-earning multiple expansions. So you don’t want to be just buying things regardless of their value. You really have to be focused on valuations.”