Emerging markets: pitfalls and possibilities

The rise of emerging markets is real but crises and volatility have kept many investors away from the sector. But for those who are conscious of the risks, there are a number of persuasive arguments in favour of allocating or re-allocating at least some resources to the sector.

Investment Industry Association of Canada (IIAC, formerly the IDA — Industry Association) conference delegates gathered in Whistler, B.C. on Monday took in some of the history associated with emerging markets investing and heard about the three mistakes investors commonly make regarding foreign content in their portfolios. Christian Deseglise, product manager, global emerging markets, at HSBC Halbis Partners also discussed his current outlook for the sector.

“The past 15 years has been characterized by excessive optimism and excessive pessimism,” he told the group. Much of the research attempting to map out the future of emerging market growth shows these countries outpacing the world over the last 10 years and suggests they will continue to do so and eventually catch up to the developed world.

Today, Deseglise says close to 80% of emerging markets equities are close to investment grade, inflation is relatively under control and countries are integrated more effectively into the world economy, which allows them to use their resources to continue growing. Countries like Korea, China and India are all net creditors, and even countries like Brazil are on the same path.

Emerging markets have 77% of the world’s population, 78% of the world’s land mass, 63% of commodities, yet make up only 22% of the global economy. In 2050, Deseglise projects the largest economies in the world will be China, followed by the U.S., India, Japan and Brazil. BRIC countries (Brazil, Russia, India and China) are also expected to overtake Europe, Japan and the U.S. and make up 50% of the world’s market capitalization by 2050.

But despite their economic growth patterns and their huge potential, Deseglise warns that fast economic growth does not necessarily mean higher equity returns for investors.

“History shows that growth and market returns do not necessarily go hand in hand,” he cautions. “It’s very important to keep this in mind when investing in these markets.”

For example, he points out that despite China’s ascension, equity index returns in the past few years have been “appalling.” Brazil on the other hand has shown relatively flat and disappointing economic growth but has delivered “fantastic equity returns, some of the best in the world.”

Index investing is the second pitfall he says investors should avoid when looking at emerging markets. Countries, sectors and stocks are all poorly captured by the benchmarks and indexes are disproportionately weighted. Poland and the Czech Republic are also on their way to becoming high income countries, while “new frontier countries” like Vietnam, Kazakhstan, and several African countries are not represented by indexes at all. Chinese construction stocks are not included in major indexes, even though construction and infrastructure development is one of the most obvious stories investors would be considering.

“Benchmarks mask a wide dispersion of returns,” and also mask wider risks he adds. “Active management can be and will be a key factor of success.”

The third drawback many investors fall into, is the assumption that since emerging market products are enjoying healthy returns, investors should put all of their money in the sector. Countries are doing well, many are trading at a discount, they’re evolving rapidly, valuations are strong, corporate governance has improved significantly in areas and global growth and liquidity remains supportive. On the flip slide, there are default risks, volatility, strange or sometimes non-existent compliance and governance structures and sharp corrections could still occur, he warns.

Risks to the HSBC outlook that affect all markets include global trade imbalances, potential for a hard landing in the U.S., increased inflation and event or specific risks like terrorism or pandemics. Threats specifically affecting emerging markets include political risk, polarized income distribution, and the slow speed of reform in some countries.

Filed by Kate McCaffery, Advisor.ca, kate.mccaffery@advisor.rogers.com