Emerging market equities:
Time to tread carefully

Emerging markets were hard hit in the second half of 2008 as investors were gripped with fear amid continuing worries of a global recession in the developed world, in conjunction with continuing paralysis in the credit markets. There is now a realisation that such an economic slowdown will inevitably affect emerging market economies, despite their ongoing positive domestic economic activity. Latin America lagged the other regions as the commodity-based continent was sold down on lower oil and raw material demand, although Chile demonstrated its modestly defensive nature arising from the ongoing participation of the local pension funds. Russia was also hard hit as ongoing margin calls led to further forced selling by leveraged investors. Meanwhile, Hungary suffered both market and currency declines on the news that it required financial support from the EU and IMF to cover the country’s short-term financing requirements.

Time to tread carefully

Our view on emerging market equities remains cautious over the coming months as daily market volatility is likely to remain very high. Clearly sentiment towards the global economy has become more pessimistic with the publication of a wide range of poor economic statistics supporting the bears. A significant downgrade in earnings estimates, as reported by Factset, has produced aggregate emerging markets earnings growth forecasts of -7% for 2008 (down from growth in the mid-teens only three months ago) putting the market on a forward multiple of 8x. Developed markets, however, now offer similar earnings growth (-8.5% for 2008) but trade on a significantly higher forward multiple of 10.8x. It is unlikely that the current downgrade cycle is over but this data represents a significant decline in expectations over the coming year and prices in much lower energy, food and materials costs when compared to a few months ago, as well as lower end demand from all major markets.

The risks to emerging markets remain in evidence: further deterioration in global growth expectations leading to the prospect of earnings downgrades, ongoing stasis in global credit markets, de-leveraging, commodity price declines, and further risk aversion. The fall in emerging market equity prices has certainly improved valuations significantly even under the lower earnings expectations already forecast, although earnings downgrades may come as analysts and companies continue to re-appraise the uncertain global outlook.

The present financial turmoil makes the outlook for 2009 very opaque: much depends on the measures that governments and central banks across the world put in place, and how effective they turn out to be. The enormous quantity of state support and liquidity which has been injected into so many economies has yet to significantly unlock the credit machine, but governments are applying pressure on financial institutions to pass on interest rate cuts and re-commence lending to both businesses and consumers. This will take time but will begin to have the desired effect of re-liquefying state, corporate and personal balance sheets. The main questions remain unanswered: how deep will the global slowdown be? how long will it last? and at what point will markets start pricing in a recovery?

Emerging opportunities

We believe that the positive story for emerging markets over the longer term remains valid; superior economic growth, albeit slower than in recent years, leading to positive development in capital markets and a growing share of global economic and stock market importance. Indeed, a number of those countries to have benefited from high commodity prices are using these windfall gains, and other fiscal packages, to support and stimulate domestic activity. The decoupling idea has clearly been disproved in respect of stock markets, but, over time we will see whether this theory applies to emerging market economies themselves. On a fundamental basis these economies are in better shape than five years ago, being driven increasingly by domestic activity, and as such ought to be insulated to some extent from the problems in the developed markets.

We are not predicting a sharp recovery in the short term but there are still a good number of companies in our universe with solid business models and strong fundamentals which are now trading at very attractive multiples and we believe that the market is pricing in a great deal of bad news. Despite our positive longer-term outlook, in the current environment it is hard to see investors rushing to buy emerging market equities in the short term, until there is some stability and clarity over the prospects for the global economy and the financial sector. In our opinion, long-term investors should maintain their positions - this is not the right time to sell - and consider whether the asset class is getting close to a buying opportunity. As and when this moment arrives, a change in sentiment and a little liquidity will quickly push emerging markets sharply higher.