Editor's note: What's driving the superior performance of emerging markets? And what challenges and risks will investors in these markets face in the year ahead? Addressing these and other issues were the three global managers who participated in Morningstar's manager roundtable on emerging markets.
Our panellists:
Chuk Wong, vice-president and portfolio manager at Goodman & Co. Investment Counsel Ltd., which sponsors the Dynamic family of mutual funds. His mandates include lead portfolio manager for Dynamic Global Value, Dynamic EAFE Value Class, Dynamic European Value and Dynamic Far East Value, the winner in the Asian equity category at this year's Morningstar Canadian Investment Awards.
Thomas Pinto-Basto, associate portfolio manager at AGF Investments Inc., a member of AGF's global equity team. He works closely with Patricia Perez-Coutts, lead manager of AGF Emerging Markets, and AGF veteran Stephen Way, who manages AGF Global Equity. AGF Emerging Markets won again in its Canadian Investment Awards category this year, marking the fifth time it has received this honour.
Chris Arbuthnot, portfolio manager at MFC Global Investment Management (U.S.) LLC. Based in Boston, Arbuthnot is a member of MFC Global's intrinsic-value team. His mandates include the Morningstar 5-star rated Manulife Global Opportunities Class.
Moderating their discussion was Morningstar columnist Sonita Horvitch, whose three-part series continues on Wednesday and concludes on Friday.
Q: Let's discuss the performance of emerging markets.
Wong: Emerging markets have handily outperformed developed markets over the past decade. The MSCI Emerging Markets Index produced a total annualized return of 11.1% for the 10 years to November in Canadian-dollar terms versus 6.3% for the S&P/TSX Composite Index and a 1.8% annualized loss for the MSCI World Index, which is the global benchmark for developed countries. But for the 12 months ended in November, the Canadian market outperformed emerging markets.
Index (total return in C$) | 1 Yr. | 3 Yr. | 5 Yr. | 10 Yr. | |
MSCI Emerging Markets | 12.7 | -1.3 | 10.0 | 11.1 | |
MSCI World | 3.8 | -6.1 | -0.6 | -1.8 | |
S&P/TSX Composite | 16.3 | 1.2 | 6.6 | 6.3 | |
For periods ended Nov. 30 | |||||
Pinto-Basto: The strong Canadian dollar is a factor in the year-to-November outperformance of the Canadian equity market.
Arbuthnot: The MSCI Emerging Markets Index has some 21 countries. Then there are the frontier countries that are not in this index, but still form part of the emerging-markets universe, for example Vietnam.
Pinto-Basto: For AGF Emerging Markets, we screen the universe, which we define as 25 countries. We focus primarily on countries that are in the MSCI Emerging Markets Index.
Thomas Pinto-Basto: The past and future economic growth of emerging countries is what makes them interesting. | |
Wong: Frontier markets generally represent those economies that are newly emerging and have less developed capital markets than those countries in the MSCI Emerging Markets Index. Front and centre in the MSCI Emerging Markets Index are the BRICs, Brazil, Russia, India and China, which are among the biggest emerging economies and collectively represent 49% of the index. China has the biggest weighting at 19%, followed by Brazil at 16%.
Q: Why has the MSCI Emerging Markets Index done so well?
Pinto-Basto: There has been a revaluation of these markets. They have offered attractive growth and were cheap relative to the developed markets. The countries' past and future economic growth is what makes them interesting. Estimates by the International Monetary Fund call for the emerging economies to grow at just over 6% in 2011, versus 4% for the global economy. The estimate for the United States for 2011 is 2%.
The drivers of emerging-economy growth include the increasing wealth of the population, investment in infrastructure, and governments and consumers with better balance sheets than governments and consumers in the developed world. Demographics are in their favour as well, so there are a lot of positives. But, the environment is becoming more complicated. You have a lot of money being created. The most recent example is the second round of U.S. quantitative easing, and U.S. Federal Reserve Board chairman Ben Bernanke said there could be more.
Arbuthnot: The Fed's mandate is to improve employment. The problem is that the easy-money policy encourages investors to search for yield, and they end up going to the emerging markets where interest rates are higher. In context, the emerging economies are starting from a much lower base, so it is easier for them to grow. The gross domestic product per capita in the United States is US$42,000. In India, it is US$1,000, in China it is US$3,500 and in Brazil it is about US$5,500.
Chuk Wong: Looking ahead, I think that the emerging-markets story will continue for a while. | |
Wong: The emerging-economies companies have also improved their transparency, accounting disclosures and corporate governance. This supports the revaluation of these markets that Thomas described earlier. Ten years ago, when I started looking at Asia, a lot of the companies had low transparency. It was difficult to understand their business models and the numbers. But this has changed. Looking ahead, I think that the emerging-markets story will continue for a while, particularly given that the mature economies are struggling with their structural problems. I don't think that the emerging markets are expensive.
Arbuthnot: It's all a question of relative risk/reward. If you look at the growth rates in emerging economies and the increased quality of the companies, these markets are attractive compared to many developed markets.
Pinto-Basto: I am going to throw a spanner into the works. My concerns are at the macro level. Going into next year, we are starting from higher valuations on emerging markets than we did at the beginning of 2010. We started 2010 with price-earnings multiples at 13-16 times forward earnings. There is a big debate about the valuation on these markets as to whether they are now fully valued, expensive or cheap. There is a need for caution.
Wong: These markets have historically been a lot more volatile than the mature stock markets. But in the last couple of years, I see some positive changes, with the gap narrowing.
Pinto-Basto: Over the past five years, the volatility has come more into line with developed markets. But there is a lot of capital, a lot of liquidity going into a very narrow, specific story, emerging markets. We could get too comfortable. If this capital decides to reverse out in a short period of time, how will the emerging markets react? What if everyone rushes for the door at the same time? I do not think that we are there yet.
Chris Arbuthnot: It is a challenge for emerging economies to deal with rising commodity prices. | |
Arbuthnot: Thomas is anticipating that there could be a bubble. At some point, there could be if valuations get ahead of the fundamentals.
Pinto-Basto: I am not a bear on emerging markets, as the growth elements are there. But, I am keeping an eye on the flow of capital into these stock markets.
Wong: I agree. There is a liquidity risk to emerging markets. When there is a lot of capital flowing into the region, it drives up the asset prices. When the capital exits, as we saw in 2008, the asset prices get hurt more than in developed economies, despite the fact that the emerging economies had better fundamentals. Hopefully, in the next few years, the emerging economies will be able to mature fast and offer greater investment breadth. There is a short-term risk regarding capital-inflow controls. Brazil, Indonesia and Thailand have already introduced them. So far, it has not caused damage to the investment environment, but we are monitoring this.
Q: What about inflationary pressures?
Arbuthnot: The easy-money policy in the West is leading to inflationary pressures in emerging markets. It is a challenge for emerging economies to deal with rising commodity prices, food prices and energy prices.
Pinto-Basto: Food and energy are a much bigger component in the emerging markets' consumer price indexes than in developed economies. In general, inflation in emerging economies is benign. But in some places, it is creeping up. Inflation in Russia is expected to increase to 8.3% from the present 7% this year. In Brazil and Turkey, inflation is expected to go down. We are watching the trends in food and energy prices.
Wong: China's recent inflation numbers are fairly flat, if you strip out food and energy from the index.
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