Emerging Markets

October 01, 2009

By Chris Dardaman, CPA, CFP®, CIMA®, CAIA® 

Countries that are in the early stages of their economic development are commonly called Emerging Markets or Developing Markets. These countries tend to be characterized by higher growth rates, higher market volatility, and higher potential for new growth than developed markets due to their early-stage position in the development cycle. India and China are prominent examples of emerging markets. These emerging markets enjoy many strengths including: young and fast growing work forces, lower labor costs, an abundance of natural resources, and a growing middle class which is characterized by rapidly increasing per capita incomes which in turn drive global demand. However, there are important risks such as political instability, local regulatory and accounting practices, and foreign currency exchange rates. Many emerging market companies are in commodity businesses such as oil, gas, platinum, etc. These companies tend to do well during periods of rising inflation and can act like a synthetic inflation hedge.

We have been investing in emerging markets, directly and indirectly, since the early-mid 1990s. In the early days we used a dedicated emerging stock fund for our more growth oriented investors, but since the late 1990s we have strategically chosen to get our emerging market exposure through our global and international managers. In light of the fiscal advancement of the emerging market countries (many of which have stronger balance sheets and lower debt ratios than the United States) we are researching the potential advantage of adding a dedicated emerging market manager to our clients’ portfolios in addition to our global and international managers.

One of the largest emerging market stories over the past 10 years has been the growth of China, which is currently the second largest economy in the world. Approximately one hundred years ago, the United States was an emerging market and about fifty years ago, Japan was just getting its economy going. Not that all countries will grow to become among the world’s largest stock markets, but you get the point. We have been, and will continue to be, invested in the fastest growing countries, but for only a piece of the overall portfolio, given the risks and volatility.

We work to control risk in these emerging markets in a number of ways, starting with active management versus a passive index which allows the manager to actively buy where they see opportunity and exit countries and companies as they see risk or overvalued share prices. Second, the manager can employ numerous quantitative metrics and qualitative attributes when making their country and stock allocations. Third, the manager can use a diversified approach with limits on the amount of exposure to certain regions of the world, country weight exposures, currencies and individual company exposure.

Opportunities in emerging markets are not limited to the equity side. Emerging market bonds also have and will likely continue to offer good investment opportunities. We have used these both directly and indirectly since the early mid-1990s and plan to continue doing so, both within certain global strategies and/or directly. Many of the emerging countries are running government budget surpluses, which continue to strengthen the value of their bonds.

Emerging market bonds offer both cash flow and currency diversification opportunities. Today it is even possible to purchase emerging market bonds in their local currencies, which can provide opportunities to profit from and hedge against U.S. dollar concentration risk. One of the more recent developments related to Emerging Market investing is the new Frontier Markets. Frontier markets are the youngest and least developed emerging markets.

Examples include: Bulgaria, Estonia, Kazakhstan, Kuwait, Nigeria, Qatar, Tunisia, Ukraine, and Vietnam. While our managers may have very small exposure here, these countries simply do not have enough capital-employing opportunities to be a major part of the global investment markets yet. As the pie chart illustrates, the U.S. portion of the global equity markets has gone from 70% in 1967 to 33% in 2009. During this time period, the U.S. stock market has gone up by 4335%, but the non U.S. stock markets have gone up even more. While the past will not necessarily be repeated, the future looks bright for emerging and frontier markets. Brightworth and the managers we use will continue to work to capitalize on emerging trends in global investing, wherever the opportunities may be around the world.