Emerging Markets Mid-Year Pulse Check

Some markets do appear to have a weak pulse right now, but any number of catalysts could act as a jump start. Global economic growth hasn’t been terribly inspiring so far in the first half of the year, but many investors have nevertheless been inspired to pour more assets into the equity markets, some of which have surged to record highs. As we hit the mid-year point, now seems like a good time to take a pulse check of emerging markets and assess our prognosis. About the Author At Franklin Templeton, we never lose sight of why we’re here: to provide investors with exceptional asset management. That’s why our independent, specialized management teams are at the heart of our business. These dedicated portfolio groups allow us to offer focused expertise across a broad range of strategies and asset classes. Several emerging and frontier markets—including the Philippines, Indonesia, Thailand and Vietnam in Southeast Asia—have seen strong returns in recent months. And there are several other notable emerging market performers where positive local macroeconomic developments have attracted strong investment flows. Given that yields on some assets seen as “safe” are close to record lows, the attraction to potentially higher-yielding, but riskier assets such as emerging-market equities has continued to grow. Of course, we’ve seen some disappointments too. Some larger emerging markets like South Africa, South Korea, Russia, China and Brazil have lost ground year-to-date through April. Reduced GDP growth forecasts certainly didn’t help and commodity-heavy markets took a double hit as reduced growth projections depressed commodity prices at the same time indications of rising production costs pressured individual mining and energy companies. In addition, sentiment in South Korea suffered amid threats from North Korea and fears Japan’s moves to depress the yen’s value would hurt South Korean exporters. In China, the authorities responded to rising property prices with measures to tighten monetary policy and restrict property purchases. In addition, some political and market developments in Brazil, India and Russia suggested that policy development was moving in a less shareholder-friendly direction.  For example, in Brazil, the government has initiated major tax claims against some large companies. In my team’s opinion, many of these issues that held back the performance of major emerging markets in recent months are likely to have little long-term impact. Tensions on the Korean peninsula tend to fluctuate over time, and we believe an escalation of the current situation into actual conflict is highly unlikely. We also think yen weakness is unlikely to be a permanent drag on South Korean export performance. And, China’s moves to cool property markets should be seen in the context of strong ongoing growth and moves to rebalance the economy toward more sustainable growth models. Some policy moves that came with short-term costs could ultimately bring long-term benefits, such as anti-corruption measures that led to reduced demand for luxury items during the Chinese New Year. In Russia, shareholder rights issues are balanced by what we see as exceptionally cheap equity valuations. Meanwhile, the overall direction of policy in both India and Brazil remains market-oriented. Most importantly, we believe recent commodity weakness does not represent a long-term trend. The Case for Emerging Markets’ Growth Despite a recent moderation in short-term global GDP growth forecasts, we still anticipate a likely reacceleration of growth in 2013 and in subsequent years, with 2012 expected to mark a low point. Moreover, we expect growth generally in emerging markets in 2013 and beyond longer term to be much stronger than in developed markets and believe such strong growth could not only drive rising demand for commodities, but also feed into corporate profitability and valuations over time. Industrialization and urbanization in emerging markets are likely to further increase commodity demand, which could push prices ahead over the long term. In many emerging economies, commodities, exports and infrastructure development could continue to be leading growth drivers, but we believe going forward, overall growth is likely to arise increasingly from domestic sources. Expanding consumer wealth is creating an increasingly large and discriminating body of middle class consumers across emerging markets, and their demand is in turn creating increasingly significant domestic economic activity. Furthermore, emerging markets have far lower levels of consumer indebtedness than is common in developed markets, giving their consumers commensurately greater capacity to ramp up demand. In addition, demographic factors are more favorable in many emerging markets than in most developed markets. With a relatively high proportion of the population in emerging markets moving into the workforce and a relatively low proportion of dependents, demographics are acting to reinforce consumer demand. Even in markets like China, where demographics are less clearly favorable, productivity gains from moves out of agriculture and into manufacturing and service industries have still provided a positive influence on growth and domestic demand. Frontier Markets – Emerging Markets of the Future These so-called “emerging markets of the future” have enjoyed strong growth from low base effects, abundant natural and human resources, the availability of easy gains from market reforms and injections of technology into relatively low-wage economies. Compared with more mature emerging markets, frontier markets are relatively under-researched, and we believe that this lack of familiarity could lead to undervaluation and pricing anomalies that we could seek to exploit through our extensive research resources. We are finding many opportunities in frontier markets globally, but with an especially dense pack of opportunities, we think Africa in general represents an investment destination all its own and one we are eyeing with particular interest. We remain aware of risks to all markets, including emerging markets, arising from the fragility of global growth, indebtedness, and a number of geopolitical risks, notably in Korea, the South China Sea and the Middle East. However, while we take account of macroeconomic considerations as part of our investment process, our central aim is to build portfolios from those stocks our research leads us to believe are most underpriced relative to their long-term potential. My prognosis: Some markets do appear to have a weak pulse right now, but any number of catalysts could act as a jump start. Taylor Scott International