Emerging market strategies move to core status

Emerging market investments have finally made the long transition from peripheral to core positions in institutional and wealthy private client portfolios, believes Daniel Enskat, head of global consulting at Strategic Insight.

Many bricks in the wall of money chasing the fortunes of developing economies originate in the US, from where investors are witnessing the rise of a global middle class, he says.

“Emerging markets as a core concept is developing round the world,” confirms Mr Enskat. “Even in the US, where until recently, portfolios were weighted 60-40 towards domestic markets, they are now being invested up to 90 per cent outside home markets.”

According to London-based fund house Schroders, a shift in investor perception, upgrading developing economies from a minor tactical to full scale strategic interest, was responsible for record inflows of more than $95bn (€65bn) into emerging markets equity during 2010. But how to benefit from dividends generated by newly developed consumer spending habits and manufacturing advantages in the developing economies remains a tougher question to answer. There is no broad agreement across the wealth management industry, with many groups opting for country specific opportunities and others preferring to concentrate on industry sectors or individual stocks.

China and Malaysia are the “top picks” of countries in the Asian market according to the quantitative model of country comparison overseen by Jonathan Garner, chief strategist for emerging market equities at Morgan Stanley. “Malaysia is re-engaging with the global investment community and the Petronas IPO has proved one of the region’s recent landmark transactions,” says Mr Garner, adding that the Malaysian currency is also particularly undervalued when compared to its peer group.

Indian equities should be the least preferred for private clients, says Mr Garner, with valuations currently 25 per cent more expensive than neighbouring Asian economies and growth slowing faster than elsewhere in the region.

REVIEWING ALLOCATIONS

A major, ongoing review of the positioning of emerging versus developed country allocations is currently taking shape at UBS Wealth Management, which runs SFr170bn (€140bn) in Asia, down from its SFr200bn pre-crisis peak. Yonghao Pu, head wealth management research Asia-Pacific, is recommending overweight positions, backed by the bank’s Research Based Advisory (RBA) process, in US and German stocks, alongside similarly bold calls on China and Korea, with a downgrade to neutral for Russian shares.

Among the key emerging markets themes being selected by the RBA team for satellite investments alongside core allocations, are agriculture, Asian consumption and the globalisation of Asian companies.

“At the end of last year, we thought it might make sense to pull some money out of emerging market equity into developed markets, as valuations climbed in the midst of the tightening cycle,” reflects Ivan Leung, chief investment strategist at JP Morgan Private Bank in Hong Kong.

But since then, markets including China, Russia and India have lost between 5 and 10 per cent, despite a lack of accompanying adverse newsflow. He is therefore reversing the decision and going back to a bullish view on emerging markets equities.

“If developed economies start to slow down, it could prove beneficial to start putting money back into emerging markets, particularly on the equity side,” says a cautiously optimistic Mr Leung. “The Chinese authorities have been very creative in damping down inflation, having used a mixture of price controls and interest hikes as part of their managed economy.”

The “big debate” for asset allocation specialists is whether portfolios should be identical, regardless of whether a client is based in the US, Europe or Asia. “Most clients in Asia prefer to have something more GDP weighted,” says Mr Leung.

“This reflects what you actually see in the world, and you can divide market allocations approximately one third in each of the US, Europe and Asia, if you believe in the ascendancy of China, India and other emerging markets.” Asian currencies are also historically undervalued, he argues, pointing to the Chinese RMB in particular, but also encompassing markets such as Singapore, Korea and Taiwan, whose cheap currencies help to boost those nations’ exports.

Currency debate has always been too focused on the US dollar, rather than a more relevant discussion to investors about what is going on in the East, claims Mr Leung, with a belief in structural appreciation of Asian currencies acting as a persuasive argument for investors. “Emerging market currencies are definitely cheap and they can add value with high productivity,” he argues.

ACCESSING GROWTH

There remains a significant body of investors, however, many of them outside Asia, who believe you cannot invest in a country’s GDP and that equity markets do not give you direct access to any growth, says Mr Leung. He gives the particular example of China, where companies’ performances are much more linked to government policy than to economic indicators.

“But during the last decade, if you have decent liquidity, GDP growth and capital markets which are functioning OK, there is a correlation between growing countries and their companies, even though there are some dislocations over the short-term,” he says. “If you are a dollar or euro denominated investor, you will benefit from both an earnings and currency perspective. Going forward, we expect higher tactical and strategic allocations to places like Asia.”

Mr Leung singles out Indonesia, where the market has risen more than 9 per cent this year in US dollar terms. “Indonesia has some of the growth attributes of China and India, sharing similar long-term structural benefits, but with less inflation problems,” he says.

“It is a nice, Goldilocks situation, where interest rates are reasonable, the domestic consumer is strong and there are commodity-fuelled tailwinds. During the thick of the credit crisis, Indonesia was one of those countries where it felt like there was nothing wrong in the world. It feels similar to Brazil a few years ago in terms of reserves and population and if they can do a few things right, it can become really exciting.”

But even looking at the world from the centre of Asia, there are emerging markets, well beyond the immediate region, yet still part of the developing world, that look increasingly attractive, believes Hong Kong-based Arjuna Mahendran, head of investment strategy Asia for HSBC Private Bank.

“A much greater awareness of the emerging world is evolving, particularly where our business clients trade in Latin America and Eastern Europe, where the natural resources and commodities story has fired their imaginations,” says Mr Mahendran.

“I just took a call from a client about Nigeria, which reflects Africa’s population growth and natural resources expansion trends. People want to know about the potential of these types of markets outside Asia.

“A lot of clients feel Asia is a very interesting place for investing right now, but want to diversify and share in the growth of other regions,” he adds.

This sceptical tendency is encouraged by Mr Mahendran. Unlike many counterparts in rival private banks, he has a very negative view of allocating to Chinese investments in the current cycle. “Clients in this region realise that a massive explosion of credit in China, and Asia in general, has created strong economic momentum, which pulled the rest of the world out of a deep economic recession,” he warns.

Wages in coastal regions rising by 16 to 20 per cent annually may also tip the economy into a different economic trajectory, and make the difference between industries being viable and unprofitable.

“Chinese companies have been turning away orders for textiles and garments, which are now being funnelled into Vietnam and Russia,” says Mr Mahendran. “Electronics exporters in Malaysia are seeing orders boosted in the last year, as Chinese manufacturers are finding it difficult to meet export demands.”

While over the last decade, China had been pulling away investment from other parts of Asia, now there has been something of a reversal, with neighbouring countries beginning to benefit once more.

He also warns about the new confidence being acquired by some US manufacturers, who are starting to expand domestically, rather than outsourcing their manufacturing to Asia.

“We still need to look at the high value-added parts of the China story,” concludes Mr Mahendran. “But due to the triple headwinds of rising wages, raw materials and interest rates, clients are in increasingly looking outside Asia.”

Arjuna Mahendran, HSBC Private Bank