Emerging markets turned in another good year in 2010. The average fund invested in India and China, for example, saw a 23.5% rise following a 60% surge in 2009, according to data from Morningstar. But investors planning to pile in on the back of this boom should tread with care. Global emerging markets are no longer “some ‘undiscovered jewel’”, says First State fund manager Jonathan Asante in the Financial Times. Indeed, anyone buying in 2011 is “about five to ten years late”. It’s not that these markets will necessarily lose you money, reckons Deutsche Bank’s John-Paul Smith, but they will “underperform developed market equities”.
There are several reasons for this disparity. First, the cheap equity valuations that got investors interested a decade ago are mostly gone. Almost $1,800bn has flooded into emerging markets during the last decade and as a result prices have been pushed up. Shares now trade “at close to parity with their developed peers”.
Moreover, says Asante, some temptingly low emerging-market price-to-earnings (p/e) ratios can be deceiving. Indices are often distorted “by very large firms on ostensibly low valuations”, many of which are “poor quality”. Firms that are still heavily government owned, for example – such as Russia’s Gazprom – “don’t exist to enrich me as a shareholder, they exist for all sorts of other reasons”. In fact, high-quality emerging-market stocks are now “quite expensive… The emerging-market universe is not only prone to bubbles, many of the best-quality companies are arguably already in bubble territory.”
Maybe so, says Julian Jessop at Capital Economics. But while some emerging markets, such as Indonesia and India, are now on high p/es, this is “not unreasonable for what are, in effect, growth stocks”. Besides, with a few exceptions, “equity valuations are close to their long-run averages in each of the three major emerging-market regions”.
Meanwhile, “there are few signs of a bubble” in the bond markets. Emerging market bonds might have gone up in price, but their yields (the overall return as a percentage on the price) are still higher than low-rated US companies and the US government. That’s in spite of the fact that many of these “so-called emerging economies… seem a better risk”. In short, “emerging-market bonds might therefore be judged relatively expensive by past standards – but this is not hard to justify”.
As for the billions of new dollars piling into newer markets, it “makes sense that capital should flow from wealthier, advanced [economies] to poorer emerging economies… Flows into emerging markets have significantly increased this year, but this is not necessarily a warning sign of a bubble.” Admittedly, some emerging economies are struggling to handle the inflow of capital, but “where growth is strong this is surely a nice problem to have”.
One factor investors must watch for in 2011 is government intervention. The capital controls, interest-rate policies and price controls introduced in some emerging markets, especially in Asia, seem to be overly focused on protecting manufacturing, says Smith. Eventually, “corporate margins (will) fall victim” to governments’ desire to curb inflation. Emerging-market shares will also be affected by events outside government control. Buoyant commodities between 2002 and 2007 have driven many emerging-market firms. With commodity prices not “likely to grow… at the same pace” this year, share prices will suffer.
Jessop concedes that bubbles may “already be developing in global commodity prices”. And that is likely to lead to “slower growth in major emerging economies over the next few years”. However, many emerging markets will continue to perform well this year. The trick for investors will be to avoid the frothiest stockmarkets – and that means any stockmarket that is “dominated by commodity stocks”.