2008: a year in Emerging Markets

 

Allan Conway, Head of Emerging Market Equities, looks ahead to 2008

Global emerging equity markets have had another strong year in 2007, continuing the run of outperformance seen in recent years. However, as we look ahead into 2008, are we seeing 'bubble conditions' in emerging markets? Our view is that if we are in a bubble, we are at an early stage, with valuations not yet at expensive levels.

Another concern for investors is the outlook for global growth. Although this continues to be important for these markets, there has been a decoupling of the performance of emerging markets from the prospects for the world economy, with many driven by domestic demand rather than exports. Our base case view is that global growth will experience a 'soft landing' next year – a relatively benign scenario (we are giving this a 60% probability at present). One note of caution is that the other scenarios we envisage (stagflation or a credit crunch-induced global recession) would both be negative for emerging markets. They have a combined probability of 40% in our view, although these scenarios would also be negative for developed markets. Overall, however, the medium to longer term outlook for emerging markets remains positive as we expect these economies to continue growing at a faster pace than the developed world over the coming years. Taken together with the huge structural improvements we have seen and factors such as the demographic advantages of the emerging countries, we believe this adds up to a robust investment case.

 

Are emerging markets in a bubble?

The continuing strong performance of global emerging markets has led many to ask whether we are in an emerging markets 'bubble'. When compared with previous stockmarket bubbles – for example, Japan in the 1980s or the Nasdaq in the 1990s – it would appear that if we are in an emerging markets bubble, then it is at an early stage and that the uptrend has further to run. Although individual emerging markets – (particularly the Chinese 'A' share market) – are arguably showing bubble characteristics, overall valuations are not expensive in P/E terms. Furthermore, relative to the MSCI World index, global emerging markets are still below the highs seen in 1994. Overall, global emerging markets look fairly valued relative to developed markets, return on equity is rising (and is well above short-term interest rates) while liquidity conditions continue to be supportive. The outlook for the global economy continues to be important for these markets (although we believe the relationship is not as strong as it has been historically). Our baseline scenario remains for a soft landing (we are currently giving this a 60% probability), which would be relatively benign for emerging markets, with global growth expected to slow to below 3% in 2008 from  an estimated 3.2% in 2007. We also believe there is scope for the US Federal Reserve to cut interest rates further, given that core inflation appears to be quite benign at present.  This should stimulate a gradual recovery in the second half of 2008. Although record high oil prices and ongoing problems in the credit markets are significant concerns, we still believe that the soft landing scenario is more likely than the alternatives, either a credit crunch-induced global recession (10% probability) or stagflation (30% probability), which would both be likely to be negative for emerging markets. Under the stagflation scenario, global and emerging market growth would be lower in 2008 than in the soft landing scenario while inflation and US interest rates would be significantly higher. Under the credit crunch scenario, although we believe US interest rates would be cut sharply in 2008 to 2% (with inflation at significantly lower levels) there would be a sharp slowdown in global growth to around 1.2% (with global emerging market growth slowing to around 4.3%). However, these scenarios would also be negative for developed equity markets and we would suggest that because of the stronger growth and better fundamentals in emerging markets (of which more later), they would be impacted less than developed markets.

 

Emerging markets less dependent on prospects for US/global growth

Overall, our view is that the fortunes of emerging markets have become less dependent on the outlook for the global economy than they have been in the past. In previous economic cycles, a slowdown or recession in the US/global economy has had a significant negative impact on global emerging markets as the demand for their exports fell. However, this relationship has 'decoupled' to some extent in recent years, with, for example the US's share of total emerging market exports having fallen significantly. Taking China as an example of the trend of 'self-sustaining' growth within emerging markets, it accounts for a larger share of exports from the emerging Asian region than the US. China's most rapidly growing export markets are other emerging countries. Furthermore, it is domestic demand that is driving the rapid growth of the Chinese economy. Even if export growth were to slow significantly, China's GDP growth would still remain strong. Domestic demand rather than net exports is also driving the economies of many other emerging markets, including Brazil, Russia, Mexico, India and Korea.

 

Growth premium in emerging markets over developed world to continue

Overall, the emerging economies have been growing by 3.6% per annum more than the developed markets since 1999 and they are now a key driver of the world economy. We believe that this strong relative growth is set to continue, with the International Monetary Fund forecasting that emerging economies will grow by 6.8% a year over the next few years compared with 2.7% for the developed world.

Another factor in favour of the prospects for emerging markets is that they have stronger overall economic fundamentals than the developed world, in terms of current account/fiscal balances and government debt. There have been huge structural improvements across many of these countries in recent years, with inflation and foreign debt levels down sharply and foreign exchange reserves having increased impressively. Longer term advantages for these markets include demographic trends. The working age population in the emerging markets is forecast to grow up to around 2040 (it is set to decline in size in the developed world from around 2010) which bodes well for their future growth prospects.

On balance, 2008 looks set to be another positive year for emerging markets, given our base case of a gradual slowdown for the global economy (however, we believe there is a 40% probability of a more negative growth scenario coming about although this would be a negative for developed as well as emerging markets). Although some of these markets (and particularly the Chinese 'A' share market) are showing bubble characteristics, overall valuations are not expensive. We believe these economies will continue to offer premium growth rates compared to the developed world and they are becoming increasingly driven by domestic demand and intra-emerging market trade and less reliant on global growth. The relatively strong economic fundamentals and demographic trends in emerging markets are also considerable advantages, and overall, the medium to longer term outlook for these markets remains positive.

 

source: Schroder Investment Management Limited