April 2011
Several of the world’s developing economies, often known to investors as emerging markets (EM), are rapidly maturing into global centers of economic growth and dynamism. This is particularly notable since emerging economies are, by definition, considered to be in the development stage, or emerging from underdevelopment. These “smaller” economies now add up to a major force.
The emerging markets comprise most or all of Africa, Eastern Europe, Latin America, Russia, the Middle East and Asia, excluding Japan. Some emerging economies are heavily dependent on commodity exports while others have extensive service and manufacturing sectors.
Growth rates across emerging markets have consistently outpaced more advanced economies since the beginning of this century, and this trend is likely to continue over at least the next few years, according to the International Monetary Fund.
While there are disparities among emerging markets, the systemically important EM nations – for example, China, Brazil and India – tend to benefit from several factors: Their citizens, businesses and governments are generally less indebted than in developed nations (largely thanks to hard lessons learned in crises in the 1990s and early 2000s), with healthier foreign currency reserves, fiscal positions and current account balances.
Also, many EM countries demonstrate increasing productivity, competitive cost structures and significant investments in infrastructure. And the expansion of their middle classes should provide greater potential to nurture domestic consumption – which may be critical to maintaining robust growth.
In fact, beginning in 2008, emerging economies began to collectively contribute a larger share of global consumption than the U.S. And there is room to grow – private consumption in EM as a percentage of GDP has lagged behind that of developed nations.
While there are risks to the longer-term outlook for EM – including inflationary pressures (such as oil price shocks) or potential volatility brought on by major systemic events – the structural strengths across many emerging economies support a compelling secular case for EM equities.
Emerging Market Companies and Equity Markets
As emerging markets have grown into key players in the global economy, EM companies as an asset class have grown to account for a substantial and increasing share of the global corporate profit pool. While emerging equity markets remain less transparent and less well covered than developed markets, macroeconomic trends bolstering the companies that conduct business in the EM space argue for investors shifting toward EM equities as a core portfolio allocation.
The EM equity universe is vast, encompassing thousands of companies across regions, sectors and industries, from small, cash-based businesses in frontier markets to major multinationals. These companies are elements of any given economy and include such sectors as energy, finance and banking, transportation, telecom, housing, utilities, mining and more. Some investors include in the investible universe those companies domiciled in developed markets with significant economic ties to emerging markets.
Many EM companies possess strong and improving fundamentals – such as healthy corporate profits, positive cash flows, low cost structures, limited leverage and manageable debt profiles – that help make them a compelling equity investment opportunity.
The MSCI Emerging Markets Index is a commonly referenced barometer of companies domiciled in emerging countries. The largest countries and sectors represented in the index are presented in the charts below (as of December 31, 2010).
Strategies for Investing in Emerging Market Equities
As investors continue to observe robust growth in emerging markets, they may consider either investing in the region for the first time or expanding their existing allocation to EM investments.
However, investors may also recognize that market volatility and currency exposure represent potential risks, and that emerging markets are diverse, with economies at various levels of development and markets at different levels of transparency and liquidity.
Investment strategies that address these issues may range from a specific focus on equities to a multi-asset approach that includes equities as a key component. In any case, at PIMCO, we see the value of active management for such a complex and shifting region.
When considering specific equity securities, investors may want to research a company’s financials, capital structure, industry, country and currency. Also, a defensible business model – and a business model that is easy to understand – is a good quality to seek in EM equities. Companies that are particularly large are sometimes partially state-owned or controlled, so it is necessary to be mindful that incentives of the sovereign are not always aligned with those of private shareholders.
Finally, investors should carefully manage risk in an EM equity strategy. Over the long term, EM equity markets have experienced some painful corrections. There are significant downside risks in EM, such as sudden policy changes or even financial or geopolitical crises in places that have been favorable for investors in the past.
Conclusion
Emerging markets are well positioned for continued economic expansion and companies in certain EM nations and sectors should benefit from the overall growth dynamics and may represent attractive investment opportunities.
Investors, however, should do their homework and be careful about how they approach this region of the world, which has experienced several market corrections and has a diverse mix of countries and economies.