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An Introduction to Emerging Markets
1.1 INTRODUCTION
Two first-time authors would have to be very brave - or indeed very foolish - to challenge the wisdom of revered investor and mutual fund pioneer Sir John Templeton. The founder of the company that, incidentally, went on to employ legendary emerging markets investor Mark Mobius, famously said: âThe four most expensive words in the English language are âThis time itâs differentâ.â
Thus, for example, investors who bought into the technology, media and telecoms boom of the late 1990s just before that particular bubble burst will be painfully aware that, that time, it certainly wasnât different. They probably wonât be too impressed either with the two words ânew paradigmâ that were bandied around by technology champions as the argument that trumped all doubters.
But are not evolution and change - the possibility that, this time, it really is different - part and parcel of the whole business of investing in emerging markets? Surely investors buy into the emerging space to tap into the growth that, at least in part, accompanies a countryâs journey from nascent or frontier market to fully paid-up member of the global economy.
And if change is indeed an integral part of the emerging markets story, should we not at least consider the possibility - as this book intends to do - that the global financial crisis, which began in earnest when investment bank Lehman Brothers filed for bankruptcy on 15 September 2008 and very much had its roots in the Western financial system, may have closed the credibility gap between the emerging economies and those of the developed world?
That is just one thread - albeit a crucial one - of a book that will also look to identify what emerging markets actually are while weighing up their attractions as an investment. It will take a long hard look at the associated risks, before considering the pros and cons of different regions and individual economies around the globe. Along the way, it will also consider what part emerging markets can play in an investment portfolio and the various routes an investor can use to gain access to them.
1.2 WHAT ARE EMERGING MARKETS?
Whether they be professional or operating on their own time, investors have a tendency to see things as two sides of the same coin. So, for example, they may look to invest for income or growth, in large corporations or smaller companies, in equities or bonds, or with an active fund manager or through a passive, index-tracking investment. The way they see the globe is no exception and, in this regard, the most fundamental distinction made is between the developed world and the so-called emerging markets.
At their broadest - taking in Africa, Asia, Eastern Europe, Latin America and the Middle East and thus individual countries as diverse as, say, Nigeria, Singapore, Hungary, Venezuela and Jordan - the emerging and frontier markets do not really lend themselves to a nice and easy soundbite of a definition. Even listing them is not exactly straightforward with the major stock market index providers unable to agree exactly on which countries count as emerging markets.
At the start of 2010, FTSE, MSCI Barra and Standard & Poorâs overlapped on 19 countries in their main Emerging Markets indices with China, India, Indonesia, Malaysia, the Philippines, Taiwan and Thailand representing Asia, Brazil, Chile, Mexico and Peru for Latin America, the Czech Republic, Hungary, Poland, Russia and Turkey for Europe and Egypt, Morocco and South Africa for Africa.
However, Argentina, Colombia and Pakistan are also included in the FTSE Emerging Markets index, Colombia, Israel and South Korea feature in the MSCI Emerging Markets index and Argentina, Israel and South Korea bolster the S&P/IFC Emerging Markets index.
Nevertheless, rather than giving up so easily and settling for defining emerging markets by what they are not - for example, the âadvancedâ or âdevelopedâ economies of the US, Western Europe and Japan - which is not very helpful, or by terms such as âThird Worldâ, which borders on the patronizing, a more useful approach might be to outline some benchmarks by which to judge a countryâs level of maturity.
These could include a countryâs growth rate - possibly the most attractive aspect of the emerging markets space over the years - in addition to the size and openness of its economy, the degree to which it is integrating within the global marketplace and the strength or otherwise of its political, legal and financial institutions.
The average level of income per citizen is another revealing factor as it is an indication of how far a countryâs standards of living are improving and whether the middle class, which is now seen by most commentators as a vital driver of any emerging marketâs internal economy, is growing.
Through its very make-up, therefore, an emerging market offers a mix of reward and risk and it is up to investors to judge how well these two elements are balanced. The rewards will stem from the potential for growth as the country develops as a nation and as an economy, both internally and in relation to the rest of the world. Meanwhile the risks will come as a result of a lack of political or economic stability or uncertainties stemming from a vulnerability to other internal and external forces.
âThe risks are inherent in the question of what an emerging market is,â says Richard Titherington, chief investment officer and head of the emerging markets equity team at J.P. Morgan Asset Management. âIn my view, an emerging market is a country that has - and there are a lot of different reasons why this may be the case - a much higher degree of political and financial risk and instability than you get in the relatively small group of countries that we regard as developed.â
The emerging markets can be split into four regions - Asia, Emerging Europe, Latin America and the so-called âfrontierâ markets, which are broadly to be found in Africa and the Middle East. All share certain general attractions for investors - and carry certain general risks. These are discussed in the next chapter but naturally they also have pros and cons that are more specific to a region or country and that is why we address the various emerging markets in six chapters grouped by geography.
Again, at their broadest, emerging markets represent some four-fifths of the worldâs population and almost three-quarters of its land mass. At the start of 2010, they accounted for roughly 70% of global foreign exchange reserves, more than half of global energy consumption and close to half of both the worldâs exports and, in purchasing power parity terms, its gross domestic product - the market value of all the goods and services produced by a country and known for short as âGDPâ.
Towering over everything else in the sector is the colossus of the emerging markets world known as âBRICâ-a term coined in 2001 by investment bank Goldman Sachs to cover the four biggest developing nations of Brazil, Russia, India and China.
According to the International Monetary Fund, China was the third largest economy in the world in 2008 with GDP of $4.3 tn - closing in on Japan on $4.9 tn but with still some way to go to catch up with the US at $14.4 tn. By the same measure, Brazil was the eighth largest economy in the world, Russia was 11th and India 12th. However, with the International Monetary Fund, as of October 2009, predicting Chinaâs GDP would grow by 9% in 2010 while that of the US would grow by 1.9%, the former looks set to be breathing down the USâs neck within a decade or two.
For its part, Goldman Sachs is projecting that in 2050 the new world order will see China dwarfing every other economy in the world with GDP of $70 tn, with the US second on $40 tn and followed by India, Brazil, Russia, the UK and Japan - with China expected to surpass the US in 2027.
Together, the BRIC quartet are the flagships of the three main emerging market regions and, at the risk of oversimplification, encompass two of the globeâs most powerful economic themes. China and India are two of the worldâs strongest domestic demand growth stories with a massive appetite for all kinds of natural resources. Neatly enough, Brazil and Russia are both leading exporters of natural resources.
Asia offers the broadest spread of emerging markets, both in terms of numbers and diversity. Chinaâs influence as a global economic superpower grows daily and the increasing spending power of Indiaâs burgeoning middle class offers great hope to investors. Meanwhile the positive example of more mature economies such as Hong Kong, Singapore and South Korea stands as a real incentive for neighbours who have not progressed as far along the development path, such as Indonesia, the Philippines and Vietnam.
Eastern Europe is dominated by Russia, whose fortunes are strongly dictated by the price of oil. The investment case for the rest of the region generally focuses on whether or not and to what extent individual countries would meet the necessary economic and financial criteria for membership of the European Union and, ultimately, the adoption of the euro - the so-called âconvergenceâ play. Some, particularly the Baltic countries such as Latvia, have expanded too fast and consequently suffered as a result of excessive debt levels.
Latin America is also dominated by one country, in this instance Brazil, which arguably may be seen as offering the best of all BRIC worlds. Not only is it a leading exporter of commodities, such as oil and agricultural products, it is also an increasingly sophisticated economy that is expected to thrive on growing consumer demand.
Across the border, however, Argentina stands as a stark warning that not all emerging markets - no matter how large they may be, how sophisticated their population and infrastructure, how many advantages they may enjoy such as, for example, a rich supply of natural resources or how much foreign investment is ploughed in - necessarily live up to investor expectations.
The frontier markets are the latest wave of emerging economies to appear on investorsâ radars and are often plays on the ongoing global demand for commodities - for example, oil in Nigeria or mining in South Africa. Very much a case of achieving potentially high reward for assuming a commensurately high level of risk, frontier markets might usefully be viewed as a bull market phenomenon where people become less discerning as their appetite for risk grows. Often they can end up investing too late in an economic cycle.
Interestingly, although they suffered in terms of, for example, reduced exports, many emerging markets avoided becoming direct victims of the global financial crisis. This was partly because they were not so reliant on the Western banking system, which bore the full brunt of the crunch, and partly because, having suffered their own market meltdowns, such as the Asian crisis of 1997, governments and companies had learnt some valuable survival lessons.
1.3 A BRIEF HISTORY OF EMERGING MARKETS
For such a well-worn expression, the origins of âemerging marketsâ as a term are a little fuzzy although consensus now has it that it dates back to the 1980s and the International Finance Corporation. That was where Antoine van Agtmael, who is now chairman and chief investment officer of investment house Emerging Markets Management, was working as deputy director of the Capital Markets Department when his book Emerging Securities Markets was published in 1984.
Four years later, the International Finance Corporation became the first organization to launch a dedicated emerging markets index, which along with its entire Emerging Markets Database was acquired in 1999 by Standard & Poorâs.
While we are on the subject of emerging markets terminology, the derivation of the other key grouping, the âBRICâ economies, is more certain. Credit for the acronym goes to investment bank Goldman Sachs, which published its paper âBuilding better global economic BRICsâ in November 2001 and has remained at the forefront of thinking on the subject ever since.
The term âemerging marketsâ may date back only as far as the 1980s but the spirit of the concept can be traced back a good deal further. Arguably China and India, the two most populous countries on the planet, are merely in the process of returning to centre-stage, having dominated the global economy in terms of share of GDP for pretty much all of the last millennium bar the 20th century.
In a neat reversal therefore, that leaves the US as the archetypal emerging market - or, at the very least, an instructive parallel with the emerging markets of today. There is a line of thought that, if you really want to tap into the growth of an emerging or frontier market, then you shouldnât invest there. Rather you should go and live in one - if youâre very optimistic about Cambodia, donât buy a Cambodia fund, go and open a restaurant or a hotel in Angkor Wat.
It is certainly a theory and one that - always assuming you are still reading and havenât dropped this book to pick up the phone to your travel agent - held true for the US in the 19th century, where one was generally better off going to live than investing through, say, a UK institution buying US assets. A catalogue of setbacks that will be familiar to any seasoned emerging markets investor - including civil war, currency crises, banking collapses, failures of infrastructure, scams and scandals - meant investors in the US endured a rough ride for a significant time.
For long periods, it was a very tough place to be a financial investor although, of course, ultimately, the country was fantastically successful and those who predicted the US would be the next big thing were utterly vindicated. As professional investor and financial commentator Jim Rogers once said: âIf the 19th century belonged to Britain, and the 20th century to the United States, then the 21st century will surely belong to China.â
1.4 A TALE OF TWO DECADES
Since their, well, emergence in the 1980s as an investment asset class in their own right, the emerging markets have experienced two distinct phases. The first was the boom and bust in the 1990s, when the loose monetary conditions of the first few years of the decade brought foreign investors flocking to the space before a number of spectacular crises sent them running for the exits just as quickly.
Ironically, it is partly because the first phase led to such pain that emerging markets could show such robust growth in the second phase, which really kicked in around 2004 and has been characterized by a period of extraordinary growth led by the industrialization of China.
The first phase followed the discovery of emerging markets by institutional and then private investors. In the mid-1980s, institutional investors, such as pension funds, began to search for investments that were less correlated - that is, moved less in line - with their existing assets at the same time as a number of developing markets began to hit their economic stride, including the four so-called âAsian tigersâ of Hong Kong, Singapore, South Korea and Taiwan.
As equity values started to soar, investorsâ appetite for risk increased and a number of investment funds were launched that specialized in emerging markets. The early performance was strong, although trading volumes remained thin and, for the time being, private investors were largely uninterested.
Problems started to emerge as early as 1989 as interest rates rose and the global downturn began, but it was not until 1994 and the Mexican peso crisis - which also dented confidence across South American markets, including Brazil - that the economic travails of the emerging markets began in earnest.
In 1997, with the Mexican crisis - also more colourfully known as the Tequila Crisis - still fresh in investorsâ minds, Thailand was forced to devalue its currency, the baht, and over the course of the next year the âAsian contagionâ spr...
