Early last month, just after the downbeat IMF/World Bank meetings in Washington, a beleaguered group of once pre-eminent investors gathered at the Roosevelt Hotel in New York to discuss the prospects for their business. In such bleak days, these men and women, managers of some of the best-known funds invested in emerging-market debt and equity, had one overriding question to confront. Can emerging markets any longer be considered a viable asset class? Euromoney, which organized the conference, listened eagerly to the debate.
The essential obstacle to believing in any swift recovery for emerging-market investing is mounting evidence that in bull markets for world equities emerging countries don’t outperform developed markets. And in bear markets they considerably underperform.
Richard Watt, managing director at BEA Associates, acknowledged that “there have only been a couple of years when the bottom 10 performing world stock markets have not mostly comprised emerging markets, and only a couple of years when the top seven world equity markets have included many emerging markets.” It’s not just the recent losses that hurt: it’s the knowledge that, even before the Asian crash in 1997, investors would have enjoyed better results buying US stocks and earning returns of 3% per month. Indeed some investors at the conference argue that it was the very attraction of such stellar returns close to home that caused the flow of foreign portfolio investment into emerging markets to slow in 1997.
Watt continues: “In the early 1990s, consultants said that the reason to believe in emerging markets as an asset class was based on four trends: a move towards democracy, the potential for stock-market capitalization as a percentage of GDP to grow in most countries, the embrace of free markets, and the potential for diversification.” The signals are mixed now regarding democracy, free markets and growing stock markets. And recent events have blown apart the last argument about diversification. “Correlations skyrocket in down markets,” says Watt.
Considering also the difficulty of constructing a sensible benchmark for dedicated allocations to emerging markets, the likelihood must be increasing that pension funds, other large investors and consultants might downgrade emerging markets from a strategic asset class and classify them as no more than a tactical option for occasional trading bets.
The mood at the conference was not uniformly defeatist, however. Michael Rosborough, senior vice-president at Pacific Investment Management Company, argues that emerging-market debt still offers promise to buyers who can properly assess the ultimate solvency, political credibility and potential for long-term growth of emerging countries: “If you do your homework, nothing in fixed income offers the potential returns of emerging markets,” he says. But even he admits that a curious aspect of emerging-market debt is that it has had only a small dedicated following and has been dominated by very short-term flows from hedge funds and banks’ proprietary trading desks. In his view, more conventional investors have struggled to understand the market at the most basic level. “You have to understand what it is. Right now it feels like equity. But fundamentally, you are lending money. And whether you lend at 300bp over treasuries or 1,300 over matters less than whether the borrower is money-good.” So hang on and hope to get repaid.
Simon Romijn, senior vice-president at Baring Asset Management, also sees bright spots amid the gloom and suggests that following the introduction of the euro, European investors will be scrambling for diversification and might be selectively attracted by emerging markets: “You have Mexico trading at 13% to 14% and this is a country which is managing its balance of payments and its fiscal situation well.” Romijn also observes that while the big balanced pension funds that have invested in emerging markets may have stopped putting in new money, they have not turned into big sellers. For the moment, they are hanging in and Romijn argues that over three to five years such patience may eventually be rewarded. Edward Vaimberg, managing director at Bear Stearns Asset Management, also argues that it might be overly pessimistic to dismiss an asset class that returned around 20% a year from 1991 to 1997. Over the same period, fundamental reforms in many emerging markets reduced their average annual inflation rates from 60% to 10%.
But no-one underestimates the near-term dangers. Says Vaimberg: “What you’ve got here is a very significant decrease in commodity prices, excess capacity in Asia, heavy financing needs in some countries and a propensity to rely on short-term debt, slowing major economies, limited availability of finance and a slow and tepid response in a number of emerging countries to tackling these problems.” Clearly risk premiums on emerging-market investments might reduce if commodity prices started to rise and some excess production capacity closed down. But that wouldn’t be enough to reverse recent slides. At the very least, emerging countries would have to offer credible policy responses.
Asked for practical investment ideas, countries to buy into on a three-year view and others to steer clear of, most investors favoured Mexico and Korea. “They have the best chance to get investment-grade status,” says Vaimberg. And very wide bond spreads. Many also liked Poland for its growth potential – even though strong economic growth in recent years has not fed through into corporate earnings – and for the brightness and credibility of its economic leaders. Stella Yiu, chief investment officer, global emerging markets, at HSBC Asset Management, favours Taiwan and indeed greater China generally. Most despaired of Russia, worrying about hyperinflation, a return to central planning or military rule. One analyst grappled for a contrarian view. “The oil and gas sector has been beaten down almost to zero. What else can you lose in Russia?” Peter Lee
