T. Rowe Price Ivestmet dialogue Emergig Market Equities: The Case Cotiues Risk ad Growth Fudametals Still Support Strog Relative Performace Scott Berg, Portfolio Maager Executive Summary Emergig market (EM) equities accout for risig shares of global GDP ad market capitalizatio ad a eve larger share of expected ecoomic growth. However, EM equity exposures withi may actively maaged global equity portfolios imply that setimet is ot uiformly bullish. Skeptics cite the political, currecy, ad corporate risks associated with EM equities. But the evolutio of EMs over the past decade suggests these cocers may be excessively iflueced by historic attributes. Forwardlookig idicators such as sovereig debt spreads reflect a improved risk eviromet. Ecoomic treds appear to favor EMs, ad we cotiue to seek out stocks levered to these treds. Although idirect exposure to the EMs ca be foud via developed markets, this is ot a complete substitute for direct ivestmet, as it may exclude idustries ad stocks cetral to the EM growth story. EM valuatios have coverged with developed markets, i part because the latter are tradig below log-term averages o growth ad sovereig debt cocers. While covetioal wisdom suggests EM equities should trade at a discout, our view is that covergece is cosistet with relative fudametals. Overall, EM valuatios appear reasoable, although the potetial for future asset bubbles remais a cocer. The low EM allocatios of some global equity maagers may reflect a preferece for bechmarkig to the Morga Staley Capital Iteratioal (MSCI) World Idex, which excludes EMs. We favor bechmarks that more fully reflect the global opportuity set, such as MSCI s All Coutry World Idex (ACWI). The strog performace of EM equities particularly sice the fiacial crisis has attracted record capital iflows, leadig some aalysts to questio whether ivestors are herdig ito the ext asset bubble. However, relative exposures withi actively maaged global equity portfolios do ot appear to reflect a bullish cosesus. IterSec, a U.S.-based cosultacy, reports that the typical global equity maager had oly a % weight i EM equities at the ed of Jue up from % i but well below the 1% weight i the MSCI ACWI (Figure 1). exteded reversal of these treds as ulikely. Accordigly, we cotiue to view these markets as highly attractive sources of stock-specific growth ideas. 1% 1 1 Figure 1: EM Exposure of Media Global Equity Maager Versus Weight i the MSCI ACWI As of 3 Jue Media Global Maager MSCI ACWI Such positioig may express a cotraria view of emergig markets or, by implicatio, a more positive opiio of developed world equities. But the persistece of the tred over the past decade, through both bullish ad bearish periods, perhaps suggests a more structural bias i EM equity exposure relative to idex weights or global GDP shares. We believe the uderlyig factors favorig EMs will persist over the medium to log term. These positives iclude reduced sovereig risk, faster ecoomic ad earigs growth, ad structural improvemets i profitability at may EM compaies. While there are dowside risks to our core sceario, ad short-term correctios are always possible, we view a Dec- Ju-3 Source: IterSec Research Dec-3 Ju- Dec- Ju-5 Dec-5 Ju- Dec- Ju-7 Dec-7 Ju- Dec- Ju-9 Dec-9 Ju-
EM I Cotext As of 3 Sept, EMs accouted for more tha 1% of the MSCI ACWI a weightig that has icreased 5% sice o the basis of strog relative returs ad a broadeig of the EM ivestible opportuity set. However, the projected chages i the global sigificace of the EMs are expected to be eve more dramatic over the ext to years (Figure ). Highlights iclude: Emergig equities already accout for 31% of total world market cap. This is more tha double their weight i the MSCI ACWI the differece reflectig substatial govermet stakes ad other log-term holdigs that are curretly uavailable for purchase or sale. Estimates suggest the EM share of total world market cap will cotiue its rapid rise: to % by ad over 5% by 3. The gap betwee capitalizatio ad free float should shrik substatially goig forward, thaks to IPOs, privatizatios, ad the uwidig of cross-owership arragemets. The EM share of global GDP is expected to rise almost as rapidly. The Iteratioal Moetary Fud (IMF) estimates that emergig ad developig ecoomies (a category that also icludes frotier markets) will have produced more tha a third of world output i U.S. dollar terms this year versus % for the E.U. ad % for the U.S. This is up from oly a fifth of global GDP i. 1 The EMs are projected to reach 39% of global GDP by 15, 9% by, ad almost % by 3. I purchasig power parity (PPP) terms, they already accout for more tha half of world GDP. Figure : EM Shares of Global Totals Curret ad Projected as of 3 Jue MSCI ACWI Market Capitalizatio GDP (i U.S.$) 13% 31% 3% 19% % Projected 3 Projected Sources: FactSet, IMF, World Bak, World Federatio of Exchages, MSCI, ad Goldma Sachs 9% 31% 55% 59% A Structurally Improved Risk Eviromet Some ivestors cotiue to be cocered about the higher volatility historically associated with EM equities. However, i this case, past performace may ot be a reliable guide to future results. While EMs are more volatile o average tha developed markets ad are likely to remai so for the foreseeable future backward-lookig volatility estimates are biased upward by the EM debt crises of the 199s. Forward-lookig risk measures, o the other had, appear relatively more beig especially whe compared with the developed world, which faces both the ecoomic aftermath of the crisis ad serious log-ru fiscal ad demographic problems: Public debt: The IMF projects that sizable fiscal deficits will push public debt i the advaced ecoomies (i aggregate) to 5% of GDP by 15. The average i the emergig ad developig coutries, o the other had, is expected to declie to 33%, thaks to relative spedig restrait ad healthy ecoomic growth. Exteral debt: EM foreig debt burdes have declied substatially sice the Asia crisis accordig to the IMF, from a average of % of export reveues i 1999 to a projected 7% i 11. Currecy risk: The growth of local EM bod markets has reduced U.S. dollar-deomiated debt as a share of total exteral debt, leavig govermets ad private borrowers less vulerable to the kid of balace sheet mismatches that proved so disastrous durig the Asia crisis. Foreig reserves: The IMF reports that EM cetral baks cotiue to accumulate hard currecy assets. These reached U.S.$.5 trillio as of mid-, up from U.S.$9 billio at the ed of. While this has added to iflatioary pressures i some coutries, it provides cosiderable protectio from short-term capital flight. The value of this safeguard was demostrated i, whe IMF figures showed the EMs as a whole were able to weather a U.S.$1 trillio declie i private iflows with relatively miimal fiacial disruptio. Iflatio: Although iflatio rates have reaccelerated i some EM coutries, most remai well below the oil-drive peaks see i. EM policymakers for the most part have reacted appropriately by tighteig moetary policy, targetig a stable log-term eviromet eve at the expese of ear-term ecoomic growth. 1 IMF, World Ecoomic Outlook database, October. INVESTMENT DIALOGUE
These structural gais have led to a steady tighteig of spreads o EM sovereig debt (Figure 3). It seems reasoable to believe that the reduced risk premiums visible i these spreads should also be reflected i EM equity valuatios. Improvemets i macroecoomic stability over the past decade have bee mirrored i the corporate sector, which has maaged to reduce fiacial leverage while at the same time raisig retur o equity (ROE). MSCI data show that the et debt-to-equity ratio o the MSCI EM Idex has falle from 31.5% i 3 to a estimated.% i. Over the same period, ROE has climbed from.% to 1.%. As opposed to beig a purely cyclical tred, EM profitability appears to be o a structural upward tred: ROE has bee higher for the EM idex tha for the World idex i every year sice 1 (Figure ) implyig that the retur differetials see over the past decade have bee solidly uderpied by the relative fudametals. Short- Ad Log-Term Growth Dyamics Favor EMs While EM ecoomies accout for a high ad risig percetage of global GDP, they are geeratig a eve larger share of global ecoomic growth. I the short ru, this tred is beig exaggerated by sluggish recoveries i the developed coutries. Curret IMF forecasts show the emergig ad developig coutries averagig 7.1% real GDP growth i ad.% i 11 versus.7% ad.% for the advaced ecoomies. Growth rates i excess of 5% are projected across much of emergig Asia, Lati America, ad the Middle East ad Africa (Figure 5). These forecasts imply that EM ecoomies will accout for more tha 7% of global GDP growth over the ext three years, i PPP terms. Loger-term treds also suggest that future earigs growth i may global idustries will be drive primarily by the emergig world: Demographics: The populatios of early every developed coutry with the sigificat exceptio of the U.S. will begi to shrik before mid-cetury. While some EM coutries (Chia, i particular) face similar futures, o average they are ot early as far alog the agig trajectory ad still have large, youg rural populatios lookig to eter their urba labor markets. Productivity: Eve more advaced EM coutries are still far behid the developed world. GDP per worker i South Korea, for example, is still oly 59% of the U.S. levels, while i Chia it is less tha 15% ad i Idia %. As a recet Basis Poits Figure : Retur o Equity As of 3 Sept 1% Dec-93 Dec-9 Dec-95 Dec-9 Dec-97 1 1 1, 1, 1,5 1, 9 3 Sep-9 Sep-97 Source: MSCI MSCI World Idex MSCI Emergig Markets Idex Sep-9 Sep-99 Sep- Sep-1 Sep- Sep-3 Sep- Sep-5 Sep- 1.% Sep-7.9% Sep- Figure 5: Projected Average GDP Growth Rates, ad 11 IMF Staff Estimates as of 3 Sept Below % Betwee % ad % Betwee % ad 5% Above 5% Isufficiet Data Source: IMF Figure 3: EM Sovereig Spreads Over U.S. Treasuries Emergig Markets Bod Idex Global as of 3 Sept 1993 199 1995 199 1997 Sources: Bloomberg ad J.P. Morga 199 1999 1 3 5 7 9 Dec-9 Dec-99 Dec- Dec-1 Dec- Dec-3 Dec- Dec-5 Dec- Dec-7 Dec- Dec-9 Sep- Sep-9 Sep- INVESTMENT DIALOGUE 3
study by the New York Federal Reserve otes, this creates ample high-retur ivestmet opportuities ad scope for techological advace i the emergig ecoomies. Cosumptio demad: Aalysts have log predicted risig EM icomes would propel a shift from export-led to cosumptio-led growth. This shift is well uder way. The BRIC (Brazil, Russia, Idia, Chia) coutries accouted for a larger share of global cosumptio growth tha the U.S. i 7,, ad 9. They are expected to almost match U.S. demad growth this year. 3 I cotrast to the cosumptio booms see i may developed coutries (most otably the U.S.) over the past decade, EM cosumer demad is beig fueled by broadeig wealth gais, ot debt. Household leverage remais low: IMF figures show et atioal savigs rates averagig more tha 33% of GDP i the emergig world versus 1% i Europe ad 13% i the U.S. Fiscal prudece, combied with ivestmet rates that average more tha 3% of GDP across the EM world, has created the coditios for the self-fiacig growth cycle we see ow. EM Valuatios Still Appear Reasoable EM equities have performed strogly over the ear ad log term ad have attracted large fud flows sice the bottom of the 9 bear market. Give this backdrop, there are cocers that EM ivestors have pushed valuatios to usustaiable levels a view edorsed by some commetators, who war of a EM bubble. Evidece of a broad-based bubble is hard to fid i the data, however. While clearly ot cheap whe compared with the market trough, EMs still appear reasoably priced especially cosiderig their superior growth prospects. At the ed of s third quarter, the price/earigs (P/E) ratio for the MSCI EM Idex was 11.3 versus a -year media of 1.9 (Figure ). At., the idex s price/book ratio was slightly above the log-term media of 1., but still well below the 7 high of 3.. Valuatio differetials betwee developed ad emergig markets have arrowed substatially over the past decade. I the case of price/book, they have eve reversed, with the MSCI EM Idex ow sellig at a slight premium to the MSCI World (as of 3 Sept ). But relative valuatios have shifted very little over the past three years the period i which the alleged EM bubble Direct ad Idirect EM Exposure The EMs are a sigificat source of earigs growth for may developed world compaies large-cap idustrial ad cosumer multiatioals i particular. This raises a atural questio: Why do ivestors eed to hold EM equities (ad the higher volatilities associated with them) whe idirect exposure to EM growth ca be obtaied via the developed markets? The aswer, of course, is that oe ideed ca fid EM growth opportuities i the developed markets ad there will be times whe these opportuities appear more attractive due to relative valuatios or other factors. However, idirect exposure is ofte a icomplete substitute for direct EM ivestmet ad may ot allow the portfolio maager to capture the iteded risk ad retur thesis. Eve i a globalized ecoomy, most compaies i most idustries still geerate the bulk of their reveues i home markets. A virtual EM portfolio of developed multiatioals ievitably will be biased toward some sectors (techology, idustrials) ad away from others (utilities, fiacials, telecoms) where local compaies are domiat. Figure : P/E Ratios Based o IBES 1-Moth Forward Earigs as of 3 Sept 35% MSCI Emergig Markets Idex MSCI World Idex 3 EM Log-Term Media World Log-Term Media 5 Although top-dow valuatios remai reasoable, there will always be areas withi a attractive asset class that appear expesive at ay give time. Today s eviromet is o differet. However, the breadth of the EM equity opportuity set, compared with years ago, should give active maagers the scope to accommodate relative valuatios withi the EMs while also balacig the growth ad valuatio potetials of EM ad developed world compaies. 15 5 Sep-9 Sep-9 Sep-9 Sep-9 Sep-9 Sources: IBES, FactSet, ad MSCI Sep- Sep- Sep- 1.1% 11.3% Sep- Sep- Sep- Is the Uited States Losig Its Productivity Advatage? Curret Issues i Ecoomics ad Fiace, New York Federal Reserve, September 7. 3 Data provided by Morga Staley Global Research. INVESTMENT DIALOGUE
is said to have formed. Moreover, there is a case that arrower discouts relative to the developed markets or eve a EM valuatio premium may be justified, both by the improved risk factors cited above ad their relative growth prospects. billio i ). Skeptics argue that these are classic sigs of irratioal exuberace. However, as already see, these iflows have ot had the impact o valuatios oe would expect i a irratioal market. Recet research from Goldma Sachs appears to support the case that EM markets have yet to peak, give still-reasoable valuatios ad above-average growth prospects. 5 Goldma aalysts examied the 5- ad -year correlatios betwee valuatio, growth i earigs per share (EPS), ad equity returs (Figure 7). Figure 7: Equity Retur Correlatios 197 through 9 data as of Sept -Year Returs vs: Startig Valuatio EPS CAGR Developed Markets -.9.3 Emergig Markets -.3.7 5-Year Returs vs: Startig Valuatio EPS CAGR Developed Markets -.37.57 Emergig Markets -..9 Source: Goldma Sachs Global ECS Research Not surprisigly, the aalysis shows that over the log ru valuatios matter ad i the developed markets they matter a great deal, with -year equity returs havig a.9 egative correlatio with iitial valuatios the implicatio beig that iexpesive valuatios are cetral to positive future returs. But earigs growth also matters, ad i EMs it appears to matter more: -year returs show a.7 positive correlatio with forecasted EPS, a stroger statistical relatioship tha betwee EM returs ad EM valuatios. I other words, EM equity returs historically have bee drive by robust growth rather tha cheap valuatios. If growth remais strog i the emergig world, as we expect, this should bode well for EM equity returs. Clearly, EM equities are o loger the udervalued asset class they were five years ago. O the other had, their growth prospects both absolute ad relative have cotiued to improve sice that time. This is i marked cotrast to the bubbles of the 199s, whe the superior (relative to the developed world) growth potetial of emergig markets was widely hailed but ot realized o a global basis (Figure ). EM Fud Iflows Are Beig Met With New Supply The other pillar i the cotraria case is the scale of recet fud iflows ito the EMs. Accordig to EPFR Global, a U.S. research firm, these reached U.S.$9. billio i first half, followig a record U.S.$3 billio i 9 (but a record outflow of U.S.$9.5 Oe reaso may be that iflows are beig absorbed by ew supply. Bloomberg reports that IPOs ad secodary offerigs i EMs soared to a record high U.S.$13 billio i the third quarter of versus just U.S.$ billio i the developed markets. While the terms of some offerigs have bee criticized as ufair to ivestors (ad thus evidece of a overheated market), to us they simply reflect the realities of the situatio: Growth is at a premium globally. As with ay strog ivestmet case, ivestors ultimately may push prices to usustaiable levels especially if latecomers rush ito the asset class late i the cycle, at a poit whe valuatios may o loger be as reasoable. However, we see little evidece ow that EM returs have outstripped the fudametals. O the cotrary, we believe there are still attractive opportuities to be foud via bottom-up stock selectio. Bechmark Choice May Costrai EM Exposure EM weights withi may global equity strategies may be well below idex ad market-cap levels because maagers are bechmarked to idexes that do ot iclude EM equities. See Do Emergig Equity Markets Deserve a Valuatio Premium? T. Rowe Price Ivestmet Dialogue, August. 5 Goldma Sachs Global ECS Research, EM Equity i Two Decades: A Chagig Ladscape, Sept. The evestmet Alliace, a U.S.-based research firm, reports that almost % of the global equity maagers i its database (359 out of the 5) are tied to the developed-oly MSCI World Idex, which also accouts for the bulk of ewly awarded U.S. global Figure : Real GDP Growth, Aual % Chage Through 15 Based o IMF Forecasts as of 3 Sept % Emergig ad Developig Ecoomies - - 191 193 World Source: IMF Advaced Ecoomies 195 197 199 1991 1993 1995 1997 1999 1 3 5 7 9 11F 13F 15F INVESTMENT DIALOGUE 5
madates (Figure 9). If ot balaced by dedicated EM allocatios, bechmarkig global equity allocatios to the World idex may cause portfolios to lag the evolutio of the EMs withi global markets. $1 1 1 1 Figure 9: Global Equity Iitial Fudigs by Bechmark I U.S.$ Billios as of 3 Jue 3 MSCI World Idex MSCI ACWI MSCI ACWI IMI Other Customized* 5 1H *Primarily combiatios of U.S. domestic ad iteratioal bechmarks Source: IterSec Research To the extet bechmark choice sigificatly impacts decisios regardig EM versus developed market exposure, it may dilute oe of the advatages of a global equity madate: the ability of global maagers to leverage their skills across the broadest possible opportuity set i order to create high-covictio portfolios withi defied risk ad retur toleraces. Icludig EM exposure i the bechmark serves this purpose i three ways: Stock selectio: The MSCI ACWI curretly cotais,11 stocks to the World s 1,57 a % icrease i the bottomup opportuity set. Top-dow sector ad/or coutry bets: Addig the 1 EM coutries to the developed markets early doubles the possible coutry/idustry combiatios. Tactical allocatio: Less costraied maagers have greater ability to make global stock comparisos ad shift from EM holdigs to idirect exposure via the developed markets based o valuatio or other factors. 7 9 Coclusios Projected treds i global ecoomic growth ad ew equity issuace suggest that EM shares of world market cap ad public float will cotiue to rise. However, the data show that may global equity maagers remai uderweight to EM equities, perhaps i part reflectig the widespread use of the MSCI World Idex as a performace bechmark. I our view, the treds that have drive EM outperformace decreased sovereig risk, structurally higher profitability, ad better relative growth prospects are likely to persist over the medium ad log terms. While there are dowside risks, such as the potetial for higher iflatio, these risks are more tha offset by the may bottom-up opportuities available i these markets. Curret relative valuatios may seem to favor idirect exposure to the EM ecoomies via developed market compaies. However, direct ad idirect exposure are both ecessary to capture the full potetial of EM growth. A case ca be made that the covergece i valuatios see over the past decade has bee uderpied by chages i relative risk ad growth fudametals. I absolute terms, EM valuatios still appear reasoable relative to historical averages. Emergig Market equities will cotiue to exhibit differet risk ad retur profiles whe compared with developed markets, despite improved fudametals. Markets remai more segmeted, with greater dispersio of returs. Liquidity is more likely to be a issue, as are gaps i sell-side coverage. At times, these factors will lead to higher volatility. However, we believe that it is precisely these characteristics that also create the potetial for active maagers (whether dedicated EM, iteratioal, or global) to ehace returs where they have the research capabilities to idetify opportuities i this dyamic asset class. INVESTMENT DIALOGUE
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