June 2013 Emerging Markets: Broader opportunities and declining systematic risk Favorable outlook for emerging markets equity and debt Alexander Muromcew, Portfolio Manager, Emerging Markets Equity Strategy Katherine Renfrew, Portfolio Manager, Emerging Markets Debt Strategy Executive summary Overall, our outlook for emerging markets is favorable, despite recent volatility caused by uncertainty over slowing growth in China and other emerging markets, and the direction of U.S. monetary policy. Over the longer term, both equity and debt securities should continue to benefit from positive economic and capital market trends. These include structural reforms, fiscal discipline, and faster GDP growth rates compared with developed markets. Emerging markets are growing rapidly in size and importance relative to the global economy and capital markets. Driving this growth are economic development, a growing middle class, rich natural resources, and freer global trade. Investment opportunities have expanded beyond traditional segments. On the equity side, some of the more attractive opportunities are outside the dominant BRIC countries of Brazil, Russia, India and China. Mexico, Turkey, Indonesia and the Philippines, for example, recently have outperformed emerging markets as a whole. In fixed income, opportunities extend beyond sovereigns to include bonds and local-currency debt. Structural changes have led to an overall decline in systematic risk, or market volatility. Economic reforms have strengthened government balance sheets, promoted local capital markets, and checked inflation all helping to increase stability and make emerging markets less risky for investors.
Growing economic influence of emerging markets Trends have converged to create broader opportunities for investors in emerging markets. Rapid economic growth, sound fiscal and monetary policies, and dynamic local capital markets are making this asset class increasingly attractive, while helping to reduce volatility. Following a series of financial crises in Latin America, Russia and Asia during the 1980s and 1990s, emerging markets were considered highly volatile. More recently, improvements in capital market infrastructure and government balance sheets have increased their stability. As a result, emerging markets compare favorably with many developed countries, particularly those in the eurozone that are burdened by high government and bank debt, and slower growth. Nonetheless, emerging markets remain subject to bouts of volatility when there is uncertainty in world financial markets. Recently, stocks and currencies fell over concerns about the global economic impact if the U.S. tightens monetary policy later this year. This worsened market jitters caused by slowing growth in China and poor prospects in Brazil, Russia, and India, triggering investment outflows and sagging currencies. The recent volatility underscores an important insight about investing in emerging markets: Equity investment opportunities extend well beyond the BRIC countries Brazil, Russia, India, and China. Some of the more attractive prospects are in lesser-known, but more promising countries, such as Indonesia and the Philippines. In fixed income, opportunities have expanded beyond traditional U.S. dollar-denominated sovereign debt to include bonds and local-currency debt. Increasing share of global GDP and market capitalization Long recognized for rapid economic growth, emerging markets have assumed greater importance in the global economy and capital markets. Their share of global GDP increased to 35% in nominal terms at the end of 2012, from about 14% in 1991, and is on the verge of overtaking developed markets in terms of purchasing power parity. Emerging market equities grew to 13% of world market capitalization in 2012, from less than 3% in 1991 (Figure 1). The persistence of higher economic growth rates suggests emerging markets share of global capitalization will continue to expand. Figure 1: Growing share of global equity market cap and GDP 13% of global market cap in 2012 / 35% of GDP (nominal) Source: J.P. Morgan economics.
Equity opportunities beyond the BRIC countries Because of their size and rapid growth rates, the BRIC countries have become synonymous with emerging markets for many investors. But recent experience shows the BRICs and other well-known countries that dominate the index may not offer the most attractive opportunities. The BRICs, representing 43% of the MSCI Emerging Markets Index, have underperformed emerging markets as a whole by 36% since 2010. A variety of structural challenges have slowed BRIC country growth rates from historical peaks and disappointed investors, causing BRIC equity markets to lag. Brazil s growth has been curtailed by weak infrastructure, bureaucracy, and uncertainty over government policy. Russia has been hurt by corruption, poor prospects for political reform, and overdependence on commodity exports, particularly oil. India s economic and political challenges include heavy regulation, which deters private investment, and persistent inflation. China faces slower growth as it transitions to a more consumer-oriented economy and away from heavy reliance on state-funded infrastructure development. The BRICs combined with South Korea, South Africa, and Taiwan representing 76% of index capitalization have underperformed by 30% since 2010. Poor relative returns from this dominant group emphasize the importance of country and security selection when investing in emerging market stocks. Investors can benefit by searching for opportunities in countries showing positive economic trends and greater potential for growth. For example, Mexico, Turkey, the Philippines, and Indonesia have outperformed emerging markets as a whole since 2010. Foreign direct investment in Mexico Mexico is particularly attractive. The North American Free Trade Agreement (NAFTA) signed in 1994 enabled Mexico to attract more foreign direct investment (Figure 2). As a result of slower wage growth, Mexico has lower industrial wages than China, making Mexico more appealing for investment in manufacturing. The country has benefited further from the peso s depreciation versus China s currency, the renminbi. Figure 2: Increasing foreign direct investment in Mexico Mexican peso depreciating vs. U.S. dollar Source: UBS. *North American Free Trade Agreement
Mexico s growing middle class and consumer-driven market Mexico s job growth in manufacturing, particularly the auto industry, has created a healthy, consumer-driven market. In turn, this has created opportunities to invest in companies providing a broad range of goods and services. The expanding middle class is creating demand for cars, electronics, housing, and energy. The critical need for urban infrastructure benefits industries producing cement, steel, and engineering services. As wages rise and more consumers can afford health care, demand increases for doctors, pharmaceuticals, and hospitals. Why emerging market stocks are attractive investments Emerging market stocks are attractive for compelling reasons. Faster economic growth has led to significantly higher investment returns for emerging markets equity over the past decade, compared with developed market indexes. Moreover, emerging market stocks appear to be cheaper, based on current and projected price/earnings valuation measures, while offering higher projected earnings growth rates (Figure 3). Finally, correlations between emerging and developed market stock returns have declined since 2009. Lower correlations increase emerging market stocks potential to enhance portfolio diversification and help manage risk*. Figure 3: Equity market valuations favor emerging markets Lower valuations and higher potential earnings growth Source: DataStream, Bloomberg, UBS. Data as of April 10, 2013. 2013 emerging-markets equity outlook While the BRIC countries are likely to improve somewhat in 2013, we believe non-bric equity markets are likely to have stronger performance. Given structural challenges facing the BRIC countries, prudent stock selection and exposure to non-bric markets are essential for improving risk-adjusted returns. *Correlations do not always remain stable and can rise during financial crises.
Opportunities in emerging markets debt Emerging markets debt offers a distinctly different set of opportunities and risks, compared to equity. While BRIC equity markets recently have lagged, the fixed-income sector has generally outperformed developed markets. Overall, emerging markets debt has benefited from structural changes leading to more stable and mature markets. Many countries have adopted economic reforms that include shifting to flexible exchange rates, liberalizing trade, curtailing inflation, and reducing government debt. With governments no longer crowding out private borrowers, corporations and quasigovernmental agencies have had greater access to capital, enabling faster economic growth. Improving credit quality By putting their fiscal and monetary houses in order, emerging market countries have made their debt markets more sustainable. Shoring up government balance sheets has reduced susceptibility to debt crises that have hurt developed markets in the United States and Europe. Today, Brazil, Russia, India and China have lower debt-to-gdp ratios than the United States, Germany, France and Japan (Figure 4). Figure 4: Emerging markets have lower debt-to-gdp ratios than developed markets Total government debt (% of GDP) in 2012 and 2013 Source: March 2013, Fitch Comparator. Greater liquidity and access to capital markets have made it easier for companies to borrow and invest, fueling profit growth and stronger balance sheets. As a result, the quality of emerging markets debt has improved dramatically. Investment-grade debt represented 58% of the market as of March 31, 2013, compared with less than 40% 10 years ago, and less than 3% 20 years ago (Figure 5).
Figure 5: Emerging markets credit fundamentals steadily improving Share of investment grade vs. non-investment grade debt Based on JPM EMBI Global Diversified Index Quality % Source: J.P. Morgan. Debt sectors are diverse across emerging markets Debt market composition varies considerably by country. Non-BRIC countries, for example, dominate the sovereign debt market, accounting for 80% of hard-currency sovereigns and 69% of local currency sovereigns in leading indexes (Figure 6). Among the BRIC countries, there are major differences in debt issuance. While India and China offer little opportunity in sovereign debt, Brazil and Russia have been mainstays of our portfolios. Brazil is particularly noteworthy for improving its credit rating by reducing debt levels, curbing inflation, and adopting prudent fiscal and monetary policies. Figure 6: Debt sector characteristics differ by country and region BRIC vs. non-bric debt market composition Source: Bloomberg, J.P. Morgan. 1 J.P. Morgan Emerging Markets Bond Index Global 2 J.P. Morgan Corporate Emerging Markets Bond Index 3 J.P. Morgan Government Bond Index-Emerging Markets 4 MSCI Emerging Markets Index
Emerging markets debt: 12-month outlook We see attractive risk-adjusted opportunities for investors, with higher spreads in emerging markets compared with developed markets. Dollar-denominated sovereign debt in many countries offers favorable spreads over developed market fixed-income opportunities, particularly after the most recent selloff. Corporate bonds offer compelling value over sovereigns, with many providing solid fundamentals and ample value, relative to global competitors. Dollar-denominated bonds both sovereigns and corporates are still sensitive to rising U.S. Treasury yields. However, if the U.S. recovery proceeds at a modest pace, as we expect, the market should support tighter spreads once volatility subsides. Current annual yields: Investment-grade sovereign debt: 3-6% Below-investment grade sovereign debt: 5-8% Local-currency sovereign debt: 5-10% While risks remain high in emerging markets, the overall level of systemic risk has declined as a result of improved government fiscal and monetary policies, and stronger local capital markets. Hence, we believe the additional yield available in emerging markets offers investors adequate compensation for the additional political, economic, and currency risks.. C11025 This material is prepared by TIAA-CREF Asset Management and represents the views of Alexander Muromcew and Katherine Renfrew as of June 2013. These views may change in response to changing economic and market conditions. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Investments in foreign securities are subject to special risks, including currency fluctuation and political and economic instability. Emerging market investments are subject to political risks and currency volatility. TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association (TIAA ). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). 2013 Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY 10017 (06/13)