Current Opportunities in Emerging Markets

Summary

2008 was clearly an exceptionally difficult year for financial

markets, and emerging market equities suffered more than most

in the rush to sell risk assets. However, the longer term prospects

for these markets appear attractive. The landscape of the world

economy has changed dramatically over recent years, and we

believe that it will be the emerging markets that will lead us

out of the current slowdown. Against this backdrop, the market

turbulence has produced some very interesting investment

opportunities, which we will explore in more detail in this article.

Steep equity market falls

In the past, emerging market (EM) equities were renowned for

displaying classic ‘boom and bust’ characteristics. However, up

until the summer of 2008, the asset class seemed to have broken

out of this pattern, and had embarked on

a long period of relative outperformance,

as investors had started to recognise its

superior growth prospects and improving

risk profile. This outperformance continued

even in the face of slowing global growth,

as despite downgrades to growth

expectations for emerging markets, it was still apparent that

they would deliver more robust growth than their developed

counterparts.

However, emerging market equities’ strong performance came

to an end in the summer of 2008 as the financial crisis worsened.

Unlike previous emerging market declines, this was largely

caused by global events in the developed world. Turmoil in the

financial markets sparked a universal flight to quality, in which

investors shunned all but the safest assets and sold others

indiscriminately. Emerging market equities underperformed

developed equities over 2008, and were the worst performing of

the risk asset classes during the main period of the crisis, wiping

out three years of gains.

So where does this leave us now?

Since the sharp falls in the final quarter of 2008, markets seem

to have started to stabilise, perhaps because the heavy selling of

assets during 2008 meant that most of the potential sellers have

already sold. EM equities have been trading in a defined range

for some months, and have outperformed their developed peers

since the start of 2009. The recovery has been led by Chinese

equities, but the Russian market has also stabilised after very

sharp falls.

Debt markets have been more resilient

Emerging market equities have been an established feature

in pension funds for some time and so are likely to be familiar

to most investors, but emerging market bonds may warrant a

short introduction. Emerging market debt has come a long way

since the crises of the 80s and 90s. Improved economic policies

have brought stability to this market. The benchmark JP Morgan

Emerging Market Bonds Index is now rated investment grade.

Better credit ratings have attracted more

investors, which in turn has boosted liquidity.

As a result, markets for emerging market

debt now comprise some $4-5 trillion of the

world’s estimated $23 trillion bond market

capitalisation (source: JP Morgan). Emerging

market debt offers a mix of sovereign,

municipal, corporate and structured debt, just as developed

markets do, in both hard and local currency, providing investors

with a range of opportunities from very high quality investment

grade to high yield assets.

Emerging market debt held up much better than equities in 2008,

meaning that they were one of the best-performing asset classes

during most of the market turmoil. They succumbed to the sell-

off in risk assets only in the fourth quarter, when spreads over

US treasury bonds widened to very wide levels. More recently,

the market has begun to show signs of stabilisation, and spreads

have started

to narrow.

The longer term outlook

However, although the short-term outlook may be opaque,

the long term investment case for emerging markets is a very

strong one. Emerging markets have young populations, growing

Current Opportunities in Emerging Markets Chris Gower, Head of European Consultant Relations, HSBC Global Asset Management

Strong domestic

demand is bucking

the global trend

consumer spending power and a burgeoning middle class. Strong

domestic demand is bucking the global trend. These countries

have over 80% of the world’s land, and abundant natural

resources.

According to the IMF, emerging markets are expected to

contribute nearly 90% of world growth in 2009, and over 60% in

2010. The main export markets of the US and the Eurozone are

of course much weaker than they were, but emerging markets’

dependence on exports to the developed world has stayed at a

steady 20% since 2000. Many emerging market governments

have also embarked on ‘self-help’ programs, by announcing

substantial fiscal stimulus packages.

In addition, with a few exceptions

(notably in Eastern Europe), emerging

markets have escaped the structural

debt problems plaguing the developed

world, and have healthy current account

and fiscal balances. Those countries

with high savings rates and modest debt

should weather the current storm fairly successfully. Emerging

market companies have also improved greatly in quality, and are

becoming increasingly ‘shareholder-friendly’. However, despite

all this, emerging markets make up only 11% of world equity by

market capitalisation, making them potentially attractive as a long

term investment.

Bearing these issues in mind, current valuations are offering

great opportunities for those investors that are willing to look

beyond the short term volatility. PE ratios are at 10 year lows,

with some areas trading at distressed levels. In particular, some

very attractive prospects are emerging in equity markets as a

result of the fiscal stimulus packages

being introduced by both developed and

emerging governments. If these are

successful in kickstarting economies,

the beneficiaries will be early stage

growth plays like industrials and

basic material stocks. Many of the

stimulus packages involve extensive

infrastructure investment, and any

companies directly related to infrastructure building will obviously

benefit from this. There are also indications that the sell-off in

energy stocks has gone too far, and some of these are now

offering value. In addition, in selected markets, consumer goods

companies that rely on local demand should continue to perform

well, as they are driven by the structural growth in the middle

class.

In the debt arena, credit spreads on emerging market sovereigns

have widened from a low of around 150 bps above the US

treasury yield in early 2007 to nearly 700 bps in early 2009.

Although headline risks remain, this widening has occurred

while the overall credit rating of emerging market sovereigns has

moved into the investment grade zone. At the time of writing

(March 2009) , the hard currency sovereign benchmark has a

yield of around 10% while the hard currency

corporate index has nearly an 18% yield. These

yields are projecting 1 year default rates of

nearly 7 to 8% in sovereigns and 20 to 25%

in corporates, while Moody’s estimates that

emerging market defaults will be less than 3%

in 2009. This suggests that there are many

attractive opportunities available.

Looking at a chart of market performance over the last year is a

disquieting experience, but for investors new to the asset class,

we are now at a very attractive entry point. Industry professionals

are even talking about a ‘once in a career’ opportunity. Although

volatility is likely to continue in the short term, it is well worth

looking beyond this at the longer term picture for emerging

markets.

Invest through a specialist

Even though emerging markets are progressing rapidly, there

are many more variables to consider than there are in developed

markets. Political, macro-economic and currency factors have

a major influence on the performance of

companies. Regulations and governance,

although improving in general, are not as

comprehensive as in developed countries,

which means that investment managers have

to understand a diverse range of countries,

regions and cultures if they are going to

be successful. When looking to invest in

these markets, it is therefore of paramount

importance to use a specialist investment manager with a strong

local network. Local knowledge is the key to unlocking the

potential of emerging markets.

Emerging markets

will contribute 90%

of world growth in

2009

For investors new to

the asset class, now

is a very attractive

entry point

First published in European Pensions, March 2009

For further information:

Head of Institutional: Richard Bottomley +44 (0) 20 7024 0756 richard.w.bottomley@hsbc.com

Head of European Consultant Relations: Chris Gower +44 (0) 20 7024 0446 christopher.gower@hsbc.com

17121/0809/FP09-0348

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