Peter Elston is a Singapore-based strategist at Aberdeen Asset Management Asia, which he joined in 2008. He is responsible for articulating the fund house's macroeconomic research and the Asian team's investment strategy. He shares with AsianInvestor his views about emerging markets.
What roles do emerging Asia, East Europe and Latin America play in the global economy?
Elston: The three regions play different roles in the global economy. These differences can be attributed in large part to each region's geology and geography. Regions which have easy access to large reserves of oil or minerals, or have expansive fertile plains, tend not to need to rely on manufactured goods to finance imports that are needed to develop domestic economies. Thus Eastern Europe and Latin America, dominated respectively by Russia and Brazil, are large exporters of oil, minerals and soft commodities. Emerging Asia on the other hand, dominated by China and India, do not have mineral or agricultural surpluses that can be exported, and thus are forced to focus on manufacturing in industries such as apparel, basic electronics and generic drugs, or services such as software and call centres. Renowned economist Paul Krugman has noted that exports should not be considered an objective in and of themselves, but as a means to an end, providing countries with the export dollars needed to finance imports.
While these key dynamics are unlikely to change in the near future, they will be affected over the longer term as emerging countries increasingly require their commodities for their own development or no longer need things to the same degree from the outside world. China most clearly illustrates this issue. Not only is China acquiring access to key commodities through a strategy of post-modern colonisation, but increasingly it is able to home grow technology necessary for its own development. Indeed, this is already manifesting in higher export prices to its developed trading partners, as the purchasing power of its population rises.
What are the key influential elements that will drive emerging Asia, East European and Latin America markets in the second half of 2009?
The key influential element that will drive each emerging region in the second half is the perceived strength of the global economy. Indeed this is what has driven markets in the first half of this year as well as the latter half of 2008. We are still in a period of global economic turbulence, in which conditions could either improve or deteriorate unpredictably. The global nature of the crisis is evident in the correlation of stock market returns. For example, in the first half of this year, the correlation of weekly returns between the MSCI Emerging Europe index and the MSCI Emerging Asia index was a high 73%. Although this was lower than the 82% recorded in the second half of last year, it is still much higher than 2005, when the correlation was just 51%. Although we would expect correlations to decline over time, they are likely to remain high in the second half of this year.
What became very clear last year was that emerging markets had not, as many had theorised, decoupled from the West. Not only were emerging countries' economies still dependent on the West, but their capital markets too were very dependent on investment flows. That said, although emerging countries are going through a very difficult period economically, as demand for their exports has collapsed, their problems are essentially cyclical. Emerging countries, particularly those in Asia, do not tend to have the same structural problems as their Western counterparts that relate to excessive leverage and low savings rates. Therefore, once demand for exports stabilises, emerging countries will be in a position to find new, domestically-oriented, ways to build growth. In the West, however, the imbalances relating to excessive leverage will take many years to unwind.
Specific factors that might drive each region in the second half would include commodity price volatility, problems within Eastern Europe's banking systems and the usual country political risk that would impact investment flows to the specific region as a whole.
In the current environment, what are the beneficial and detrimental factors with respect to emerging markets?
The most beneficial factor for emerging markets is also a detrimental factor, as it relates to emerging markets generally having high growth economies. While this high long-term growth presents many interesting investment opportunities, it also presents many headaches. First, high economic growth encourages companies to expand too quickly, at the expense of balance sheet strength and management depth, which at best tends to result in low returns on capital and at worst in bankruptcy. Second, high growth tends to be more volatile, which means that foreign capital flows will also be volatile. Such inflows and outflows, which can be very large relative to, say, foreign direct investment flows, can cause central banks problems when it comes to managing exchange rates and maintaining strong banking systems.
What sectors do you expect to outperform in emerging Asia, East European and Latin America markets respectively?
Looking longer term, the sectors which we would expect to outperform in each region are those where the region has a particular competitive advantage. For example, Russia has a clear competitive advantage in oil and gas. Demand for energy is unlikely to fall, nor is the transition to renewable energy likely to be quick, so we would expect Russia's oil and gas sector to outperform over the long term. Over the short term, however, the relative performance of the oil and gas sector relies on the oil price, which is very hard to predict.
Latin America's competitive advantages are also related to commodities, but in a much broader sense. Not only does Brazil have huge offshore reserves of oil and gas, but it is rich in iron ore as well as soft commodities such as coffee and sugar.
In Asia, countries such as Indonesia, the Philippines and Malaysia, are all dependent on commodities, but it is a different story for the larger emerging economies such as China and India. These countries do not have surpluses of commodities, and so, as mentioned earlier, have had to rely on exports of services and manufactured goods to generate the export dollars that are needed to pay for imports of, say, machinery, aircraft and commodities. Thus emerging Asia's key competitive advantages lie in manufacturing and services.
What is your order of preference for emerging markets: Asia, East European or Latin America?
We think that manufacturing can provide a much more valuable competitive advantage than commodities, as it can enable companies and countries to build home grown brands. Companies such as Samsung Electronics, Acer, Asus and HTC are all home grown and stand as testament to Asia's ability to innovate. There is little brand value in commodities however, and so excess returns on capital may not be available to the same extent as in manufacturing and services. Furthermore, commodity-rich countries have a tendency to become complacent, not needing to create means of financing imports. There are numerous academic studies to show that there is an inverse correlation between a country's long-term growth rate and the extent to which it is commodity-rich. Japan and South Korea are very good examples of countries which have few commodities but which have grown at high rates in the last four decades. Our top preference therefore is for emerging Asia.
Between emerging Europe and Latin America, we prefer the latter. First, Latin America tends to have a broader range of commodities while countries like Russia are more of a one-trick pony, relying on oil and gas. Second, we have found that corporate governance is generally better in Latin American companies.
Should investors who are sitting on profits consider pulling out of emerging markets now? Or do you suggest holding on? And is it too late for new investors to enter the market at this point?
We are positive about the long-term prospects for emerging markets and so, as we would much of the time, suggest that investors hold on. That is not to say that we are positive about the prospects for emerging markets in the second half. The fact is that it is always difficult to predict markets over short time frames, now more than ever.
As for new investors, we would recommend starting a monthly investment plan, whereby they invest a certain amount every month. That way, if markets fall, investors will not suffer too much. Conversely, if they rise, investors will capture some of this price appreciation.
Our best advice to investors is to be honest about their investment time horizon and to behave accordingly. If they have a long time horizon, they should not worry about short-term volatility. If they have a short time horizon, they should not be investing in equities, and certainly not emerging markets equities.