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The developing recovery

Emerging markets have rebounded strongly, well ahead of their developed market counterparts.

Recent trends offer encouragement that a semblance of rationality may be returning and investors are beginning to re-appreciate the fundamental appeal of the asset class.

To put this in perspective, the MSCI Emerging Markets index was up by 14.3 per cent for the first four months of 2009 and up by 54.1 per cent from October’s lows. The developed-market-focused MSCI World index was down by 4.7 per cent this year.

Emerging markets continued their strong run in early May, as more than $10bn of portfolio flows moved into emerging markets during a six-week window in March and April.

This raises a question about whether price volatility is an appropriate measure of risk.

Given the strong recovery in equity markets, it seems the correction of last year was predominantly a result of relative illiquidity in emerging markets. Foreign investors had excess leverage, and, when forced to unwind, sold indiscriminately to raise cash, ignoring the compelling fundamentals of emerging markets.

Economic data continue to suggest that the worst of the economic storm may have passed. China has been a great support, with ongoing loose monetary policy and fiscal spending.

This, coupled with some better newsflow, has led the market to upgrade 2009 China GDP growth forecasts towards the critical level of 8 per cent. The “less bad’ data from the US, and Chinese support, have given investors confidence that emerging markets’ strong performance is more than a dead cat bounce.

Two of Hexam’s favourite emerging market countries currently are China and Russia. China is supported by a massive stimulus package, significant reserves and a population that is only just starting to consume goods and services.

In contrast, at the end of last year, Russia was widely reported to be bust despite owning the world’s third-biggest reserves. The ensuing retreat by international investors, who dominate Russian capital markets, left equities staggeringly cheap and Hexam bought heavily.

Now the world has realised that Russia is not bust, its stockmarket has rallied by around 77 per cent from February lows and our funds have profited handsomely. Russian equities are not for the brave but rather the rational and pragmatic.

Hexam believes that emerging markets will continue to outpace developed markets in the recovery. Initially, this will be driven by investors buying back exposure that they had been forced to sell as part of the earlier deleveraging process. It is, however, the fundamental long-term story that matters.

Key structural factors suggest emerging markets will drive global growth in the coming decade – notably, lower household debt, better economic balances and developing capital markets.

Despite this advantage, emerging markets still trade at a 10 per cent discount to developed equities on 2009 earnings’ estimates and a 20 per cent discount on 2008 earnings. This gives plenty of scope for a re-rating of emerging markets, which would drive further long-term outperformance.

It is now more important than ever for investors to ensure they have sufficient exposure to the growth potential of emerging markets.

Over the 10 years to the end of April, the MSCI Emerging Markets index outperformed the FTSE 100 by nearly 180 per cent.

This long-term outperformance despite several “market crises” supports Hexam’s view that the risk is not in owning emerging markets (the prevailing myth) but, given the headwinds facing developed markets, in not having enough emerging market exposure.

Bryan Collings is Ignis Hexam global emerging markets fund manager


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