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Emerging maturity

Lazard Asset Management emerging markets manager James Donald says the failure of Chinese stockmarket volatility to trigger a major sell-off shows how emerging markets have developed as a major asset class.

Emerging markets have provided equity investors with tremendous returns over recent years, yet two months into 2007 and the performance of the asset class is looking a bit patchier.

After a positive start to the year, the MSCI Emerging Markets index had declined by 1.9 per cent in dollar terms by the end of February, with a mixed bag of returns at individual country level. Malaysia, Pakistan and Peru experienced double-digit gains over the period and other markets achieved decent returns.

Conversely, the equity markets of China, Russia, Hungary, Thailand and Venezuela have all struggled in recent weeks for a variety of reasons. China’s Shanghai index had continued its ascent after its breath-taking 130 per cent rise in 2006 but dropped by 9 per cent on one day in the final week of February.

There was no clear trigger for the sell-off but profit-taking by investors after the extremely strong rally in Chinese stocks over the past 12 months, coupled with the intention of the Chinese government to increase its investigative efforts into illegal investor trading activity, seems to have affected market sentiment.

The Shanghai index rebounded the following day to reverse some of the losses before falling back again the day after.

Elsewhere, Russian stocks have been hurt by a falling oil price, the Hungarian stockmarket fell in mid-January on adverse inflation news and Thailand’s SET index has fallen by 8 per cent since the bungled imposition of controls on foreign investment on December 18.

But it is the Venezuelan stockmarket that has probably experienced the most turbulence, falling by 17 per cent in January as alarmed investors reacted to recently re-elected president Chavez’s pledges for nationalisation that form part of his plans to transform the country into a fully socialist state.

For any investment manager whose process is predicated on bottom-up stock selection, macroeconomic and political considerations help frame portfolio construction. The monitoring and evaluation of macroeconomic and political trends must form part of a risk-control process.

The situation in Venezuela presented itself as a rare and extreme case of country risk and meant there was no real protection for investors in Venezuelan stocks.

A creeping trend towards protectionism can also be detected in the behaviour of other emerging economies of late. Bolivia nationalised its oil and gas industry last May to give the state more control and a bigger slice of profits. Ecuador’s economy minister has labelled much of the country’s debt “illegitimate” and suggested that the country may repay only 40 per cent of its foreign debt. Russia flexed its muscles in late 2006 by forcing Royal Dutch Shell and its partners to sell half their stake in the massive Sakhalin II oil and gas project to Gazprom.

Previously, the events witnessed in Caracas and, more lately, Shanghai may well have triggered a broad and deep sell-off in the emerging markets. Many of the emerging markets have been knocked out of their stride in response to the volatility in the Chinese market, the impact has been relatively moderate by historical standards.

With regard to developments in Venezuela, we expect the prospect of any future contagion in Latin America to be limited.

Many countries in the region appreciate that Venezuela has the oil reserves to back up a socialist system but others do not have that luxury and cannot afford to take the Chavez route. Even Chavez risks much if he continues to pursue such policies over the longer haul.

There is a deepening of democracy evident in Latin America. This has been visible recently in Brazil where President Lula was re-elected last October. Lula may be a socialist but has proved to be no autocrat. Mexico, another major regional player, has also exhibited a stronger commitment to democracy over the past decade.

After four years of substantial gains, emerging market equities may have got a little ahead of themselves. The Chinese, Indian and Russian markets, as well as the energy, financial and healthcare sectors, look relatively expensive right now.

That said, overall valuations continue to be more reasonable than in the developed markets although the discount has narrowed considerably over the last few years. The financial productivity of emerging market companies remains higher than for developed markets and has been for 23 consecutive quarters.

Protectionist sentiment and trade friction might be on the increase in places and current valuations may look relatively expensive in others. However, the maturity of the asset class, based on widespread macroeconomic reform and a broader investor base, as shown most recently by the lack of fallout from the Venezuelan sell-off and the absence of an extreme market reaction so far following the sharp drop in Chinese stocks, helps to underline the continued long-term attraction of emerging market equities.

For investors who can bear significant volatility, we believe the asset class remains a sensible place to have a small portion of their portfolio. Investors should not expect returns over the next four to five years to match those of the past four years but we feel the opportunity remains to generate good performance.

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