Emerging Markets: Has Their Time Finally Come?

Ronald D. FRASHURE and Charles H. WANG

Perspectives, Vol. 3, No. 4

(Editor's Note: Views expressed in this article are those of the authors only. This article does not constitute investment advice. Neither OYCF nor Perspectives is qualified to give investment advice. We publish this article here for its independent academic value, and OYCF and Perspectives disclaim any connection to any investment advice that a reader may infer from reading this article.)

With the world poised at a number of critical crossroads-between recession and growth, war and peace, up and down markets, optimism and pessimism-now seems to be a particularly timely moment to reconsider the case for emerging markets. During this difficult year, emerging equity markets have actually held their value more successfully than developed markets, with declines of considerably smaller magnitude than those seen in the U.S., Europe and developed Asia. Could this be a forerunner of an extended period of outperformance in these markets, which have held out much promise to investors over the past decade or more but have so far largely failed to deliver?

The term "emerging markets" was coined by the World Bank's International Finance Corporation in the early 1980s. Typically, emerging markets are in countries that are in the process of industrialization, with lower gross national product (GNP) per capita than more developed countries. Of the 130 countries that the international financial community generally considers to be emerging or developing countries, approximately 40 currently have stock markets. Emerging markets became the new frontier of global investing in the late 1980s and saw spectacular returns in the early 1990s, only to be followed by an exceptionally long span of volatile and disappointing returns. These markets seemed to lurch from one period of intense crisis to another with only intermittent spells of relief. The most intense storms during the 1990s were the Mexican peso devaluation of 1994 and its subsequent "tequila effect" contagion, the Asian financial crisis of 1997-1998, and the Russian ruble devaluation and debt default of 1998, which spread systemic risk into developed markets by way of the Long-Term Capital Management debacle. Most recently, the Argentine financial crisis has been in the spotlight.

During the longest U.S. bull market in history, emerging markets might better have been termed "submerging markets," declining 43% from December 1994 to October 2001, during a period when the S&P 500 index gained 130%. The disconnect between the apparent potential of emerging markets and the actual returns of recent years has been extremely trying for investors, and many have decreased or eliminated their allocation to this asset class.

Despite the current sentiment, there is a strong case to be made that now is an ideal time for emerging markets investment. Like value investing's renaissance in 2000 following the burst of the Internet bubble, market turning points are often unconventional, uncomfortable, and even painful in the short term. It is important to remember that when the economic outlook and investor sentiment are at their worst, even a small turn of events toward the positive can be enough to reignite markets. This paper outlines some key observations that suggest emerging markets offer a compelling investment opportunity at present.

1. Historically Low Valuations

Valuation levels are extremely strong for the emerging markets asset class and even more so for active, risk-controlled emerging markets portfolios, which have a single-digit price-to-earnings ratio, with attractive earnings growth forecasts. Overall, compared to other asset classes, the emerging markets are the most attractively valued equities available to investors.

In addition, from a timing perspective, the emerging markets asset class is selling at historically low valuation levels as compared to similar assets in developed markets. Based on price-to-earnings ratios, for example, valuations are currently half those of developed markets, compared to an average of 0.75 over the past fifteen years. It is hard to imagine that such compellingly strong fundamental value can long be ignored.

2. Economic Triggers - Near Term

Of course, valuations alone will not ensure strong equity market returns if there is no improvement in the underlying economic climate. However, as has been demonstrated many times, markets are discounting mechanisms and tend to rise in advance of actual recovery in economic and corporate earnings growth. Emerging markets have historically been especially sensitive to perceptions of the global economic cycle and have tended to be one of the more responsive asset classes in discounting economic change. We saw this in Mexico in the mid-1990s, when the stock market recovered well in advance of the actual turnaround in the economy and currency.

While we believe that the prospective economic recovery in the developed markets from the current global recession is likely to be more drawn-out and less ebullient in the early stages than in past recoveries, we still think that the emerging markets are likely to gain significantly from a discounting of world economic recovery. This anticipation could start within the next six to twelve months, and possibly sooner, based on historical precedent.

In addition, as we consider the world economic outlook, certain areas within the emerging markets are actually among the few pockets of potential strength in global growth. Ironically, from a global point of view some of the currently stronger economic growth prospects would be the former state-managed economies of China, Russia and central Europe. Most of the developed economies appear to have uncertain prospects for next year, especially the United States and Japan. The emerging markets, in contrast, appear better poised to recover, having experienced the downturn earlier and in many cases more severely than their developed counterparts.

3. Market Volatility Change as a Spur to Outperformance

In addition, emerging markets have historically shown good performance when global equity market volatility has reached a peak and then declined. Global market volatilities have continued at a high level after their September peaks, but a reduction of uncertainty regarding world political and economic issues could be expected to reduce volatility levels-which would be beneficial to emerging markets based on past patterns.

4. Economic Triggers - Long Term

Beyond the near-term triggers, there are some long-term economic and political developments that may be quietly laying the foundation for a sustained period of better performance from these countries. These would include the world's increased recognition of the strategic importance of developing nations, new models for economic development that stress free markets and individual initiative, and evidence that nations that followed now-discredited approaches to development (such as the old Asian economic model) are already striking out on new paths.

In the aftermath of the September 11 terrorist attacks on the United States, there is a heightened awareness of the importance of key emerging markets in global security. Recently, for example, the U.S. has stepped up economic assistance to supporters in the war against terrorism, including Pakistan, Egypt and Turkey. It seems likely that a greater degree of political partnership with these nations could well translate into greater investor attention, stronger capital flows and positive market performance.

Beyond the immediate effects of the current anti-terror campaign and its focus on a few key strategic countries, it is also likely that there will be broader support for emerging markets globally, as their pivotal role in the new world order emerges. In his 1997 book The Big Ten - The Big Emerging Markets and How They Will Change Our Lives, Jeffrey Garten, Dean of the Yale School of Management, argues that potential political and economic instability in the emerging markets could create havoc for the world economy. The changed realities after September 11 and recognition that lack of economic opportunity provides a fertile breeding ground for terrorism are expected to solidify global support for measures aimed at reducing instability in the world's developing regions. Greater stability would be expected to have a positive effect on emerging markets, reducing the risk premium and boosting equity values. Even a focus on just the largest markets would likely boost the overall asset class, as Garten's "big ten" alone accounts for over 60% of total emerging markets capitalization (based on the MSCI Emerging Markets Free index).

Another stimulus to the long-term economic performance of emerging markets is greater recognition of free, open, transparent markets in promoting economic growth. Despite the noisy protests of "anti-globalization" groups at recent multinational meetings, there is a growing consensus that economic development promotes personal freedom, and that the two phenomena are closely linked. This viewpoint is persuasively explored by Amartya Sen, winner of the Nobel Prize in economics, in his1999 work Development as Freedom. Greater acceptance of the linkage between economic development, free markets and individual freedom is likely to increase over time, stimulating growth in emerging capital markets.

On the purely economic level, leading economists with influence on emerging markets policymakers, such as Rudi Dornbusch of MIT, have been arguing that free markets solve problems most effectively. In the essay on "Long-Run Growth in Emerging Countries" in his 2000 book Keys to Prosperity, Dornbusch shows the importance of three key characteristics for growing economies - openness, macro stability and small government. In our experience, Dornbusch and other economists of similar orientation are being listened to carefully by policymakers in important emerging economies. Wider acceptance of their views can be expected to promote long-term, stable growth.

Evidence that this is already occurring can be seen in Asia. Asian companies and policymakers demonstrate a clear movement away from the old economic model that prevailed prior to the 1997-98 financial crisis towards a more open, market-driven system. The old model was one in which the consumer saved prodigiously, banks lent carelessly, and borrowing corporations over-invested with poor returns. While creating the illusion of steady growth, this model was in fact unsustainable, as the economist Paul Krugman pointed out in his now-famous 1994 Foreign Affairs article, "The Myth of Asia's Miracle." His view, controversial at the time, was borne out by the Asian financial crisis three years later.

While the degree of progress towards a new Asian economic model varies from country to country, our observations confirm a general shift towards a framework where consumers spend more and borrow more. Lending institutions in turn have tighter lending standards, putting corporations into competition for capital and necessitating higher returns on investment. This new paradigm offers the prospect of more sustainable growth and higher valuations for investors.

5. Assessing the Long-Term Fundamental Case

Finally, the fundamental case for emerging markets investment remains sound. The two decades since these countries first made forays into the capital markets are only a short period in world economic development and a fleeting moment in history. Yet during this period emerging markets have come a long way in establishing sound fiscal and monetary policies, restructuring their economies, addressing corporate governance, and improving their economic fundamentals. Keeping this in mind, the potential for continued rapid, positive change in these economies and markets is still very strong.

Long-term fundamental positives for the emerging markets include:

o Large, rapidly industrializing populations
o Undervalued currencies
o Declining current account deficits
o Improving infrastructures
o Competitive wages
o Increased competition, reform and restructuring
o High savings rates
o Long-term propensity toward growth

Of course, emerging markets vary a great deal in their political realities, their cultural and national identities, and their legal and economic institutions. Many emerging market populations are still in poverty and lack the basic means for development. Great attention needs to be paid in understanding the multifaceted nature of these countries and to distinguish among the different stages of development. In short, investment in these markets remains challenging. However, we believe that with use of a wide array of information and skilled application of disciplined analytical tools, it is possible to avoid troubled areas and selectively invest in high-return countries and companies.

Diversification of portfolio risk is also a positive feature of emerging markets investing that investors would do well to keep in mind. Over the past fifteen years, a 40% emerging markets/60% EAFE (The Morgan Stanley Capital International Index for Europe, Australia, and Far East) mix has provided superior risk-reduction and higher returns than a 100% EAFE portfolio, when combined with U.S. equity investments.

6. Conclusion

We think investors should look past the current market anxiety and make a careful and objective appraisal of the present opportunities in the emerging markets. We believe this asset class will serve investors extremely well in the long term, and that the current valuations and outlook justify an increase now in emerging markets allocations for global fund sponsors. The current uncertainty, while uncomfortable in the near term, provides a classic long-term buying opportunity.

(Mr. Ronald D. Frashure is the president and co-chief investment officer of Acadian Asset Management. Dr. Charles H. Wang is the director of research and emerging market fund manager of the same company.)