Investment Insights Invesco Global Equity Emerging Markets A 2012 outlook Ingrid Baker Portfolio Manager Invesco Global Equity Many investors have watched from the sidelines as emerging market equities provided double-digit gains in seven of the previous nine years, fearful of bad timing and that perhaps the opportunity had passed. As we enter 2012, the MSCI Emerging Market Index has recently lagged other indexes (declining roughly 18% over the past 12 months), providing what we believe to be a compelling investment opportunity. Summary Emerging markets, once an asset class favored primarily by the dedicated global investor, came of age during the past decade. The Asian Crisis of the late 1990s, Russia s default on its sovereign debt and the recurring currency devaluations of Latin America are all distant memories of a different investment era, particularly against the current European backdrop. In today s slow-growth global economy, we believe emerging markets continue to offer investors an opportunity for growth, potentially higher returns and valuable diversification. Before looking to the year ahead, we will take a step back to highlight the investment merits of this asset class. Economic growth The significantly higher levels of economic growth within the emerging market countries are well-documented. As highlighted in figure 1, 2012 forecast growth rates in China and India dwarf the expectations for most developed markets, particularly the Euro area, UK and the US. This advantage may result in many benefits, including stronger banking and financial systems, industrial expansion into a broader array of sectors than were previously available and significant support for corporate earnings growth.
Figure 1 2012 Invesco GDP Growth Forecasts Growth Forecast (%) 10.0 8.0 6.0 4.0 2.0 2.4 2.0 0.3 1.0 0.0 Euro Area UK US Japan Source: Invesco analysis, as of Dec. 1, 2011. The above are Invesco forecasts for the year 2012. 7.6 India 8.7 China Over the past 20 years, the combined consumption of the emerging markets, as illustrated in figure 2, has risen from approximately 22.5% to 37% of the world s total and the current pace of growth is unmistakable. As this trend has contributed to the remarkable returns achieved in emerging market equities over the past decade, we believe there is a strong case for the investment opportunity in the years ahead. However, the enormous potential for economic growth in the years ahead is even more obvious when comparing the 37%-share in world consumption to the 80% share in the world s population. Consumption may have risen considerably, but obviously, there is still great potential. And this is even truer for market capitalization where the emerging markets share was only 12.3% at the end of 2011. 1 Figure 2 Share of Global Consumption US % 40 Emerging 35 30 25 20 90 91 92 93 94 95 96 97 98 99 00 01 02 Source: JP Morgan. Annual data from Jan. 1, 1990 through Dec. 31, 2001. 03 04 05 06 07 08 09 10 11 Government finances The irony of global investors comfort with developed market finances entering the past decade, versus the perceived riskier emerging markets, cannot be overstated, especially given recent European events. While the persistent downward pressure on developed market sovereign debt ratings has become routine, an average debt ratio of 93.5% of gross domestic product (GDP) for this group should be of significant concern. Contrast this number to the emerging market average of 34.9%, as well as an average fiscal deficit of 2% of GDP versus 7.5% for developed countries and your perception of risk is reshaped. Under these circumstances, it is not surprising that the emerging market group has enjoyed frequent upgrades, resulting in investment grade status for the emerging market sovereign debt index (EMBIGD). Government finances, as reflected by 2011 budget deficits as a percentage of GDP, are highlighted in table 1. A key factor relative to longer-term growth, this is an important investment consideration in assessing global equity markets. Today, the need for massive economic stimulus by the US and British governments has led to projected 2011 budget deficits of almost 9% of GDP, slightly trailing Greece. This deficit spending has 1 Source: MSCI as of Dec. 31, 2011. Investment Insights: Emerging Markets A 2012 Outlook 2
significant potential consequences for domestic interest rates and inflation expectations. Dependent on foreign capital to support the needed fiscal stimulus, the US has increasingly become vulnerable to higher bond yields to finance its spending and inflationary pressures stemming from an increase in the money supply. The more solid underpinning of the leading emerging economies provides valuable financial flexibility for current and future economic policy initiatives. In the case of China, the government is well positioned to potentially address the game-changing nature of the global slowdown. It may begin to transition the Chinese economy away from heavy reliance on public demand, foreign direct investment and rapid expansion of capital resources into an economy driven by private sector demand, more of a domestic focus, and the creation of a larger services orientation to GDP. If successful, this bodes well for China, the world s second largest economy behind the US. Table 1 2011 Budget Deficit as a Percentage of GDP Developed Emerging US Euro Area UK Japan Greece Brazil Russia India China 8.7 4.1 8.8 8.3 9.5 2.7 0.8 5.4 1.8 Source: The Economist as of Dec. 31, 2011. Diversification and decoupling Since the MSCI Emerging Markets and the MSCI World Index are obviously not perfectly correlated, investors have historically enjoyed diversification benefits by adding emerging market equities to their broader portfolio. But concerns have increased that this is no longer the case. While there is a clear secular trend of increasing correlations between emerging markets and the US equity market (a concern often shared by US-based investors), please note the cyclicality illustrated by figure 3. During the Asian crisis of the late 1990s, correlations were still quite low, reflecting the US market s ability to shrug off the challenges then facing the Far East. Conversely, emerging markets saw a rapid recovery in correlation after the crisis was resolved, only to see a decline in correlation during the global recession following the Telecommunications, Media and Technology (TMT) bubble. While the recent financial crisis, the largest systemic shock faced since the 1930s, has led to yet another increase in correlations, we believe that the different macroeconomic and fundamental underpinnings of emerging markets will once again lead to fluctuation in market correlations. As a consequence, whereas the secular uptrend, due to increased globalization, is likely to remain intact, our view is that investments in emerging markets should continue to provide diversification benefits in addition to the added return potential inherent in the asset class. Figure 3 1 Year Rolling Correlation Relative to MSCI US Index MSCI Emerging Markets Correlation (%) 100 75 50 25 0 12/91 12/92 12/93 12/94 12/95 12/96 12/97 12/98 12/99 12/00 12/01 12/02 12/03 12/04 12/05 12/06 12/07 12/08 12/09 12/10 12/11 Source: Morgan Stanley. Monthly data from Dec. 31, 1991 through Dec. 31, 2011. Additionally, emerging markets dependence upon exports to the US are gradually decreasing, largely due to increased exports to other emerging economies as well as growing domestic consumption. Thus, the potential for a decoupling from the US economy, in our view, has significantly improved. While the magnitude of the US economy will naturally continue to impact all corners of the globe, emerging markets are diversifying their sources of revenue and growth meaningfully and at some point in the future will become less tied to the ups and downs of the US market as they once were. Investment Insights: Emerging Markets A 2012 Outlook 3
Valuation We believe that the most compelling investment case for emerging market equities today focuses upon relative and absolute valuations. After declining 20% during the second half of 2011, we believe emerging market equities are trading at attractive valuation levels, particularly in comparison to other equity classes (table 2). In our view, the long-term investor currently enjoys a compelling risk-reward tradeoff. Emerging markets have traded at a meaningful discount to the US market on most measures, including on price to earnings and price to book value, while paying a higher dividend yield. Notwithstanding the higher embedded growth as reflected in the underlying return on equity (ROE), we believe this discount in valuation has more to do with historic relationships than current fundamentals. Whereas the broad non-us index has traded even cheaper still, we do believe this is warranted given the current growth profile of emerging market equities. Table 2 Market Valuations P/E Price/Book Price/Cash Flow ROE (%) Dividend Yield (%) MSCI EM 10.6x 1.6x 6.8x 14.9 2.9 MSCI EAFE 12.0x 1.3x 6.7x 10.5 3.9 MSCI USA 13.7x 2.0x 8.8x 14.8 2.2 Sources: MSCI Inc. via FactSet Research Systems, Inc. and Invesco, Dec. 31, 2011. Conclusion The emerging markets have come a long way since the Asian Crisis and the Russian debt default of the 1990 s. Given the global nature of today s economies, we expect emerging markets to continue to be volatile. However, we believe demographics, favorable economic growth prospects, attractive valuations and valuable diversification benefits may all support the appeal of the asset class. The primary concern regarding emerging markets is that economic growth has begun to slow down or fade. Will countries such as China be able to manage a soft landing, or suffer the effects of a popping bubble? While the growth rates in most markets have adjusted downward from lofty double-digit levels of a few years ago, we believe their advantage over developed markets has, in many cases, actually widened. A further slowing is inevitable, but we have been encouraged by the proactive steps taken in many markets to manage a moderate economic slowing, as demonstrated by recent Purchasing Managers Index (PMI) data, as opposed to a hard landing. In many markets, such as China, the strength of their reserves and a very reasonable fiscal deficit, provide much needed flexibility. We believe investors with a focus on high quality, well valued companies spanning the capitalization spectrum will be well positioned for the current opportunity in emerging market equities. Important information Securities issued by foreign companies and governments located in developing countries may be affected more negatively by inflation, devaluation of their currencies, higher transaction costs, delays in settlement, adverse political developments, the introduction of capital controls, withholding taxes, nationalization of private assets, expropriation, social unrest, war or lack of timely information than those in developed countries. Foreign investments may be affected by changes in a foreign country s exchange rates; political and social instability; changes in economic or taxation policies; difficulties when enforcing obligations; decreased liquidity; and increased volatility. Foreign companies may be subject to less regulation resulting in less publicly available information about the companies. Investment Insights: Emerging Markets A 2012 Outlook 4
Note: Not all products, materials or services available at all firms. Advisors, please contact your home office. Past performance cannot guarantee comparable future results. Asset allocation/diversification does not ensure a profit or eliminate the risk of loss. All data provided by Invesco unless otherwise noted. The opinions expressed are those of the authors, are based on current market conditions as of Dec. 31, 2011, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This should not be relied upon as the sole factor in an investment-making decision. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. This does not constitute a recommendation of the suitability of any investment strategy for a particular investor. The MSCI Emerging Markets Index SM is an unmanaged index considered representative of stocks of developing countries. The Emerging Market sovereign debt index is an unmanaged index considered representative of sovereign debt issued by developing countries. The MSCI World Index SM is an unmanaged index considered representative of stocks of developed countries. The MSCI EAFE Index is an unmanaged index considered representative of stocks of Europe, Australasia and the Far East. The MSCI US Index is an unmanaged index considered representative of the universe of companies in the US equity market. The MSCI USA Index is an unmanaged index considered representative of large- and mid-cap US equity market performance. An investment cannot be made in an index. Price-earnings (P/E) ratio, the most common measure of how expensive a stock is, is equal to a stock s market capitalization divided by its after-tax earnings over a 12-month period. Price-to-book (P/B) is the market price of a stock divided by the book value per share. Return on equity (ROE) is net income divided by net worth. Diversification does not guarantee a profit or eliminate the risk of loss. Invesco Advisers, Inc. is an investment advisor; it provides investment advisory services to individual and institutional clients and does not sell securities. Invesco Distributors, Inc. is the U.S. distributor for Invesco Ltd. s retail products. Both entities are wholly owned, indirect subsidiaries of Invesco Ltd. invesco.com EM12-INSI-1-E 02/12 2281