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Emerging prospects

After two consecutive years of negative equity returns, investors are understandably sceptical when they are told that emerging markets present an excellent opportunity. However, both the short- and long-term outlook is the most attractive it has been for some time.

In our view, the asset class is chronically underowned by international investors. Emerging markets typically behave as a warrant on global recovery – so much has been obvious already in this cycle. Since the end of September, the MSCI emerging markets free index has rallied by more than 30 per cent. In comparison, the S&P 500 and FTSE Europe ex-UK rose by 7 and 6.1 per cent respectively over the same period.

Of course, further outperformance depends on a recovery in the US. To stimulate the economy last year, we witnessed an aggressive reduction in US short-term interest rates to a 40-year low of 1.75 per cent. An easing US monetary policy is extremely beneficial for emerging markets&#39 sovereign debt and domestic rates. That tends to help equity markets.

But even assuming that the US recovers only slowly, valuations in the emerging markets look as persuasive as they have done for several years. In fact, it is hard to see where the downside risks lie. The ongoing valuation gap between Asian companies and their counterparts in the West implies that Asia stands a good chance of outperforming when the global recovery takes shape. The less fashionable smaller Asian markets look particularly inexpensive.

In this regard, Asia&#39s corporate sector reflects a general improvement in the region&#39s financial health since the crisis of 1997/98. The governments of several Asian countries have taken measures to effect corporate restructuring, including reform of debt-laden banking sectors.

They have nearly all delinked their respective currencies from the dollar, an advantage in the recent export-led boom, since the US is still the region&#39s biggest single customer. Today, the region has the cushion of large current account surpluses. That is allowing policy responses to be redirected toward domestic demand. To our mind, this side of Asia&#39s story is ignored, yet appears sustainable.

For many, China&#39s admission into the World Trade Organisation in December should be a key driver for Asian markets. This comes at a time when the domestic economy is in an enviable position of being able to counter the slowdown in global economic growth with strong domestic demand. Size alone will force international investors to sit up and take notice of its potential.

For the rest of Asia, China&#39s accession to the WTO is a call to shape up or ship out. One of the biggest and immediate worries for the region is the threat of the mainland sucking in a massive chunk of foreign direct investment inflows with its cheaper-priced labour-intensive exports. This is a potent threat, albeit one not entirely new to China&#39s neighbours.

At the portfolio level, it means Asia&#39s low-end factory economy is best avoided and all the more reason to focus on consumer stocks, financials and services that tap the region&#39s steady rise in domestic purchasing power.

With the launch of euro notes and coins on January 1, the process of EU enlargement took on a new dimension, which should be a key driver for the Emerging Europe, Middle East and Africa (Emea) region. Eight Central and Eastern European countries – Poland, Hungary, Czech Republic, Slovenia, Slovakia and the three Baltic countries – are likely to conclude negotiations on EU membership by the end of 2002 and join by 2005.

In terms of investment opportunities, out of the eight, the countries with the most developed stockmarkets are Poland, the Czech Republic and Hungary. Of these, Hungary is the most advanced in terms of negotiations, while Poland is the least advanced, primarily due to the importance of its agricultural sector and its blanket opposition to a phased free movement in labour. Despite these hurdles, Poland&#39s political importance means it is highly unlikely that it will not be admitted in the first wave.

Latin America&#39s problems, which at their worst are encapsulated by Argentina, are unlikely to be solved in the short term. But Mexico has shown other countries what can be achieved. One of the main drivers of its economy over the past few years has been its relationship with the US, both geographically and through the North Atlantic Free Trade Association. Of course, the country has been adversely affected by a weak US economy in the short term, which is why the market merits caution. But Mexico should benefit from a resurgent US market.

Emerging markets are certainly not for the proverbial widows or orphans but we are confident that gaining exposure at this juncture can provide the longer-term, less risk-averse investor with the prospect of strong returns.

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