Tilting towards fast-growing economies

In this extract from Mercer’s recent research paper, A Strategic Tilt to Equity Markets in Fast Growing Economies, co-author, Harry Liem, discusses the case for investing in developing economies and some implementation alternatives.
The global equities portfolios of most Australian institutional investors have been largely dominated by stocks listed in countries that are developed and recording relatively low economic growth rates. Portfolios have invariably been benchmarked against the Morgan Stanley Capital International (MSCI) World Index, focusing mainly on the developed markets of the US, Europe and Japan. Recently, there has been interest in expanding the breadth of equities portfolios to include markets of faster-growing economies in Asia and elsewhere, as part of a broader move to increase exposures to a range of non-traditional asset classes.

It can be argued that Australian portfolios already have sufficient exposure to fast-growing economies due to the relatively high level of integration of our economy with those in Asia. Mercer believes this argument takes insufficient account of the unique risk and return characteristics displayed by markets of developing economies.

Markets of most of the world’s faster growing economies are included in the MSCI Emerging Markets Free Index and/or the MSCI Far East ex-Japan Index. The Emerging Markets Index (EMF) comprises about 55% Asia excluding Singapore and Hong Kong, 20% Latin America, 20% Middle East/Africa and 5% Europe. The Far East ex-Japan Index comprises the Asian countries in the MSCI EMF except for India and Pakistan and includes Hong Kong and Singapore.

Asian markets were especially buoyant in the early-1990s but have since lagged behind the rest of the emerging markets, with the Asia crisis in 1998 and the SARS crisis in 2003 being contributing factors. In addition, Asia has benefited less from the recent commodities boom than regions such as Russia, South Africa and Latin America who are net commodity exporters.

Both Emerging Markets and Asia ex-Japan are trading at significant discounts to developed markets based on standard valuation measures, as per the following table.

Valuations, June 2005
Market Price

Source: UBS. Valuations are based on earnings for the year ended December 2005.

One of the major attractions of fast growing economies is simply the opportunities presented by their strong
economic growth. In addition, faster growing economies such as China have enormous latent potential with a growing consumption-oriented middle class.

WHY INVEST IN FAST-GROWING ECONOMIES?

• Real GDP growth rates in the developing world averaged 3.5% pa over the 13 years to 2003.
• Compared with 2.6% pa for the developed world.
• Enormous potential. On a purchasing power parity basis, China may surpass the US as the world’s largest economy within a decade.
• Developing markets trade at a discount, which means that investors are not required to pay for the extra potential. Admittedly, the discount reflects higher risk.
• Low (albeit increasing) correlation with developed markets.
• More scope for adding value from active management.
• Many developing economies are super-competitive in manufacturing and, increasingly, in services.

Naturally there are drawbacks with investing in fast growing economies, but we believe these have diminished during recent years. In particular, progress has been made in the areas of market integrity and
protection of minority shareholders, especially in Asia, post the 1998 crisis.

WHY NOT?

• Volatility may be high and crises can precipitate contagion effects.
• Strong GDP growth does not guarantee strong stockmarket returns.
• Transaction costs are higher, liquidity is lower and currency risk may be difficult to hedge.
• Company management is arguably more variable in quality and less focused on advancing shareholders’ interests, while standards of investor protection are lower than those prevailing in developed markets.
• Concerns of an SRI nature. Some investors boycott certain markets because governments are dictatorial or have unacceptable human rights records.

RECOMMENDATIONS

Mercer believes there is a strong case for higher allocations directly to fast-growing markets. An exposure in line with world market capitalisation should be sought. A higher weighting is easily justifiable for investors prepared to accept additional risk.

One alternative for gaining exposure to equities in markets of fast growing economies is to award broad international equity mandates to managers who generally hold significant investments in those markets. This can, however, compromise manager selection. The preferred approach, therefore, is to appoint a manager specifically for the segment, or even two, depending on the level of the allocation, after first determining the extent to which existing managers already invest in these markets. This approach has the advantage that the full field of potential candidates can be considered.

This article is based on a paper written by Garrie Lette, Harry Liem, Geoff Stewart and Jen Thompson.

© 2005, Mercer Investment Consulting
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