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Flight to safety and flight to quality have been the prevailing investment strategies of many investors. How will this affect emerging market equities, considering that emerging markets have generally been considered riskier than developed markets?
Durham: The flight to safety has been expressed in investor flows into money market funds, into US government bond funds, and even into US equity funds in recent months. The source for some of these flows inevitably has come from emerging market equities, which due to their recent plummet they are no longer regarded as immune from the global downturn. While emerging markets are in far better economic and fiscal health than the developed markets, they will continue to be seen as a riskier asset class and so will be dependent on the return of investor risk appetite before flows return.
What is your outlook for emerging market equities in the coming 12 months?
I'm very optimistic that 12 months from now emerging market equities will be considerably higher than they are now. Trading at the ridiculously low P/E multiple of around seven times, they are at their cheapest in a decade. Corporate earnings growth is obviously slowing down, and so low valuations have to be seen in that light. But even though growth will slow it is the emerging markets that will be responsible for all GDP growth in the world in 2009. I think emerging market equities will bounce back once investors have fully processed the reality of a sharp global recession. And the strength of domestic demand in the emerging markets will be stress tested.
Do you expect emerging market equities to outperform or underperform other markets in 2009?
I would expect outperformance of developed markets in 2009. I do believe that fundamentals will prevail, that at some point their relative strength and the extent that rising domestic demand has made them somewhat less vulnerable to dependence on exports to developed markets will help these markets outperform. They also have less exposure to credit instruments at the heart of the rot in developed markets, mortgage penetration is much lower than in developed markets so less exposure to real estate, and generally stronger public and corporate balance sheets. On the latter, an example is the corporate debt to equity ratio that is now 15%, compared to 85% 10 years ago.
What are the opportunities available in emerging market equities at the moment?
They are all over the place for investors with long time horizons. Markets such as Russia and Brazil trading at single-digit multiples. Investors who missed out on the BRICs (Brazil, Russia, India, China) story originally get a mulligan in buying into these markets again at bombed out levels. Emerging markets probably have farther to fall, but itÆs in times like these that fortunes are made.
The current accounts of Asian markets that are net commodity importers will benefit now from falling commodity prices. And the markets that are big commodity exporters will also benefit again when global growth picks up again û and I think it will be faster than some assume given the amount of liquidity that has been pumped into the system in recent months.
Infrastructure assets have been devalued because of their dependence on credit, which has all but dried up. But the demand for these projects will remain and when credit markets thaw then there will be opportunities there.
Which particular emerging markets do you think fund managers favour, based on your EPFR Global data?
I think fund managers are generally running scared from most markets right now. But based on our fund flows data China had been showing some strength, and well before the just announced $540 billion fiscal stimulus. We've noticed a pickup in investor demand for pure China equity funds in recent weeks and months. If you go back to mid-July, China funds that we track have actually had net inflows of about $3 billion. They had outflows up until that point.
Russia equity fund outflows of late have also been moderate relative to market performance. And the geographically diversified global emerging market equity funds have posted inflows in four of the past six weeks, receiving about $2.2 billion in fresh money. That is remarkable given that these funds have returned about -35% during this period.
Which emerging markets are out of favour?
Fund managers will probably be staying away from fiscal deficit countries, such as South Africa, Hungary, Turkey, Poland, etcetera. In the current climate, countries with relatively strong fiscal positions and balance sheets will be favoured. In a credit crisis, it's better to be invested with the creditor than the debtor.
Within emerging markets, which sectors are getting the most inflows?
Information technology appears to be doing well. They've also increased exposure to consumer staples and energy. I think IT is favoured because many IT firms are flush with cash. Consumer staples make sense as a defensive sector. The buying of energy must be due to attractive valuations.
Which sectors are experiencing the most outflows?
Emerging market funds have reduced most aggressively their materials weightings, followed by industrials. The materials selling is clearly due to falling commodity prices.
What do you think are the biggest challenges in finding suitable investments in emerging market equities under the current market condition?
Having a long enough time horizon for the investments to come to fruition. We shouldn't underestimate the profound damage that has been done to investor confidence in all markets globally, including emerging markets. It will take time for confidence to return. The shocks that we are currently going through are shaking the very foundations of investor confidence in capital markets, their institutions and the notion that investments can generate positive returns. And that's probably a good sign that a bottom may be forming.
How many emerging markets equities funds does EPFR Global track?
We're tracking 2,718 dedicated emerging market equity funds with $465 billion in total assets. That's down from about $800 billion at the end of May. Astonishing, isn't it?
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