FTAdviser.com

Advertising

At the height of the financial crisis, risk aversion drew many investors away from the equity markets. But recent glimmers of economic hope have helped ease investor wariness and sparked new interest in equities, particularly in emerging markets.

Following months of dramatic underperformance, including their worst month on record in October 2008, emerging markets have outpaced the developed markets year-to-date. The MSCI Emerging Markets standard index gained 17.9 per cent over the four months to April 30, against respective declines of 2.5 per cent and 2.7 per cent for the S&P 500 and MSCI EAFE indices. Investors have been jumping on the rally, reversing the sharp outflows that accompanied the dramatic decline in commodity prices that began in mid-2008.

This change in direction marks a major shift in investor perception, as they see that emerging markets have remained fundamentally strong throughout the global economic turmoil. Confidence in these markets seems to be making a comeback, as investors appear to be looking beyond near-term earnings to the longer-term prospects of individual companies.

The extended outperformance in emerging markets earlier in the decade corresponded with a significant upgrade in fundamentals, both in absolute terms and relative to those of the developed world. It can, therefore, be argued emerging markets were punished unfairly during the recent global market decline. They have continued to offer a compelling combination of growth, value and attractive fundamentals throughout the downturn, including higher expected earnings growth and greater profitability than developed markets.

Expected two-year earnings growth in emerging markets is far higher than in the developed world, both US and non-US. In addition, because many emerging markets companies began deleveraging their balance sheets after the crises of the late 1990s and early 2000s, their debt-to-equity ratios have remained roughly steady at about 55 per cent. The debt-to-equity ratios in developed markets, which hovered close to 100 per cent before the present credit crunch, have dropped to just over 49 per cent for non-US developed markets and 60 per cent for the US as a result of forced deleveraging.

It is noteworthy that emerging markets companies achieved significant improvement in their return on equity (ROE) even as they deleveraged after the various currency crises, and their ROE remains attractive relative to that of developed markets.

A favourable ROE based on a strong balance sheet with limited leverage provides downside protection. Unlike highly leveraged companies, those without much debt can maintain their current ROEs without any additional growth in earnings, or even with some earnings declines, simply by taking on more debt.

Emerging markets proved not to be completely immune to events in the global economy, as the decouplers had argued. While trade between the emerging countries has gained in importance, countries such as China, Taiwan, South Korea and Mexico still rely heavily on exports to the developed world.

However, emerging market economies started out in a far stronger position to weather the global downturn than their developed counterparts. Their financial institutions had limited exposure to global credit problems, focusing instead on traditional loan growth in their own countries. In addition, there continues to be healthy investment-led growth in many emerging economies. Public and private capital has been flowing into significant infrastructure projects in India, China, the Middle East and Russia. These investments, along with growing domestic consumption, have helped provide some protection from weaker export demand.

Most important, emerging markets are sound at the macro level, having generally addressed their fiscal imbalances, improved their balance of payments, lengthened the maturities of their obligations and increased their levels of foreign reserves. A growing number have established or enlarged economic stabilisation funds or sovereign wealth funds, further reducing their vulnerability to external pressures and giving them the means to help sustain domestic growth through interest-rate reductions, fiscal stimulus and other initiatives. Although current account balances have dropped since the beginning of the market turmoil, they remain well above those in developed markets and are expected to recover in coming years.

All of this indicates that, as investors move past the worst of the global credit malaise, emerging markets should be able to rebound relatively quickly, without having to rebuild financial systems. Meanwhile, the developed economies will still be hampered by the lengthy deleveraging process.

Emerging markets likely bottomed in October 2008 and the worst part of the crisis is likely behind them. However, the recovery process takes time and can include many false starts. Volatility is likely to continue until a more consistent and positive global environment takes hold.

In light of the very strong performance of emerging markets prior to the 2007 equity market peak, periodic corrections, such as those last year, are digressions in a long-term upward trend. In fact, such corrections offer a second chance to investors seeking exposure to the asset class, allowing them to purchase stocks at bargain prices. Experience has shown that buying emerging markets stocks during a correction period has generally been profitable for intermediate to longer-term investors.

Emerging markets, especially China, India and Brazil, are expected to provide much of the global growth for this year. The International Monetary Fund estimated in January that emerging economies would expand by more than 3 per cent this year, versus a 2 per cent contraction for developed countries.

Today’s uncertain environment - any environment, for that matter - calls for a consistent investment discipline that focuses on underlying company fundamentals, which are the drivers of long-term returns. Based on their fundamental characteristics, there are attractive opportunities not just in the largest emerging markets, but also across smaller markets such as Indonesia, Pakistan and Turkey.

Companies related to domestic consumption and infrastructure spend, which should continue regardless of developments in the global economy, still score well. Many of these stocks sold off dramatically late last year despite good fundamentals and stable earnings on the back of rising domestic incomes and stimulus spending. There are also opportunities among companies with strong market positions and very cheap valuations, such as banks, which have declined in sympathy with banks in the developed world despite generally attractive fundamentals.

Based on their demographics and sovereign health, emerging markets offer excellent opportunities for investors with longer-term horizons. These markets also remain undercapitalised. Developing economies represent more than 80 per cent of both world population and land mass, nearly 70 per cent of foreign reserves and more than 50 per cent of GDP (measured at purchasing power parity) - but still just over 10 per cent of market capitalisation.

Urbanisation and industrialisation continue apace, creating millions of new jobs with higher wages and increasing domestic consumption. Emerging-market governments are more responsive to their citizens than at any time in history and developing the infrastructure to meet their needs and aspirations. The rising income level is also a source of funds for global investment.

With their combination of low valuations, superior growth prospects and, most important, solid balance sheets at the sovereign, corporate and household level, it is highly likely developing markets will remain a growing source of attractive opportunities and perform well over the long run.

Ray Prasad is senior portfolio manager at Legg Mason affiliate Batterymarch Financial Management