Global Asset Allocation



Global Asset Allocation

Brian C Gendreau, PhD

Invest in Emerging Markets Now?

The performance of emerging markets over most of the past two years can only be described as dismal. MSCI’s Emerging Market Free Index fell 31 % in 2000 and is down by another 23% so far this year. All regions have participated in this downdraft, with Latin America down 30%, Emerging Asia down 5 1 %, and the composite Eastern Europe, Middle East, and Africa down 46% since December 1999. In the wake of the September 11 terrorist attacks, the outlook for emerging markets looks, at first glance, even bleaker than before. Heightened uncertainty, volatile markets, and a global economy moving into recession all point to a deteriorating climate for riskier assets such as emerging market equities.

While the outlook for emerging markets seems clouded, there are a number of reasons to believe that this asset class is approaching a point at which it may begin to outperform. These include:

• Valuations are at levels that in the past have been followed by strong equity market performance. This can be seen in the relationship between the monthly aggregate price-to-book (PIB) ratio in the emerging markets and performance of the MSCI Emerging Market Free Index over the 12 months after each monthly P/B reading (see Figure 1). In the past, low P/B ratios have tended to be followed by strong performances in emerging equity markets. P/B ratios tend to be low after a sustained market sell-off, when equity values have been beaten down and the expected rate of return on equity has to be high for investors to buy the stocks.

The standard criticism of valuation-based arguments is that equities are not necessarily attractive just because they are inexpensive, and it is possible to be lured into a "value trap," in which cheap stocks stay cheap for an extended period of time. Note, however, that value traps have rarely occurred when P/B ratios in the emerging markets have fallen as low as the current level of 1.3x. In all instances except one, P/B ratios that low have been followed by double-digit increases in equity prices over the next year.

• Sovereign spreads are at levels that in the past have preceded high equity returns. Sovereign yields in the emerging markets reflect perceptions of country risk and are widely used as key components of cost-of-equity estimates. As a result, equity prices in the emerging markets tend to fluctuate inversely with sovereign yields and with the spread of sovereign yields over U.S. Treasuries. Historically, sovereign spreads have varied systematically with business conditions and have provided information about the expected return on equity. When business conditions are poor, capital is flowing out, selling has driven sovereign bond prices clown and sovereign spreads up, and equity prices are low. Under these circumstances the required (if not expected) rate of return on equity is high: Investors will buy equities only if they believe they will be rewarded with an exceptionally high return.

The tendency of sovereign spreads to forecast future equity returns in the emerging markets is evident in Figure 2, in which the average yield spread between sovereign bonds and U.S. Treasuries has been plotted against equity returns between December 1990 and October 2001. The data are weighted by equity market capitalization and include only those countries that had sovereign bonds outstanding at each point in time.[1] As of the end of October 2001, the average equity market cap-weighted sovereign spread was 472 basis points. As can be seen in Figure 2, spreads that wide have usually been followed by strong equity market performances.

• Policy stimulus in the United States should help global growth and the emerging markets to recover. Contrarian indicators such as P/B ratios and sovereign spreads suffer a drawback in that they provide little or no information about the timing of a possible upturn. While they suggest that the preconditions for a rally are falling into place, a concrete catalyst may be necessary for the markets to turn convincingly. The most obvious catalyst will be a turnaround in global growth. Barring major new shocks (including renewed terrorist attacks), policy stimulus in the United States should set the stage for a rebound in 2002. The Federal Reserve has already cut its Fed funds rate target ten times this year, bringing it down to 2.0% from 6.5%, and SSB economists expect further cuts. Congress has already legislated $45 billion in public spending for reconstruction, the military, and the airlines, and an additional fiscal stimulus package of as much as $100 billion is in the works. SSB economists expect this monetary and fiscal stimulus to halt the decline in GDP growth by the second quarter of 2002 and to generate a sustained upturn in growth beginning in the following quarter. A recovery in the United States should, in turn, boost global growth.

Equity markets typically anticipate economic upturns and begin to rise before activity actually turns positive. When those markets do turn around, risk assets - including the emerging markets - arc likely to outperform. That certainly was the case during the last U.S. recession. According to the National Bureau of Economic Research, business conditions in the United States peaked in July 1990 and hit a trough in March 1991. Emerging market equities underperformed developed-market equities (as measured by returns on the MSCI Emerging Market Free and MSCI World Indices) in July through November 1990 by -29.2% versus -12.7%. Over the next four months, however - before the U.S. recession was over - emerging market equities outperformed (by 34.6% versus 12.3%).

The Long-Term Outlook for the Emerging Markets

Even if investors are persuaded that the emerging markets may be nearing a period of outperformance, many investors are likely to be deterred from investing in this asset class by perceptions that, in the long term, the rewards do not justify the risks. Since December 1987, the first date for which MSCI’s indices are available for the emerging markets, the average return in those markets has exceeded that in the developed markets, but the volatility of those returns has also been higher by a wide margin, making the risk-adjusted returns lower (see Figure 3). Nonetheless, there are reasons to believe that returns in the emerging markets will be higher in the future. This is not because the long-term GDP growth rate in the developing economies is higher than in the developed economies (though the consensus among economists is that it is). Nor is it because better economic policies and economic reform will permit them to "converge" to the developed markets -though some (such as Singapore) already have, and others (such as Chile and Hungary) are well on their way. Instead, returns are likely to be higher because of demographic changes, improvements in corporate governance, and the interaction between the two.

Demographic Trends Favor Emerging Markets

Currently, a massive shift in age structures is under way in the advanced and developing countries that will affect savings, investment, and capital flows for decades to come Populations are aging rapidly in Europe, Japan, and the United States, but the large, young populations in the emerging markets are moving toward their middle years, in which they will be earning and saving more. This can be seen in Figure 4, which presents United Nations figures on the dependency ratio in 1998 and indicates the level it is expected to reach in 2025. (The dependency ratio is the number of persons under the age of 15 or 65 or older divided by the number of persons aged 15-64.) By 2025, developing countries are expected to have dependency ratios almost as low as the developed countries had in 1998, while this ratio is expected to rise markedly in the developed countries. Since countries with low dependency ratios have higher savings, these trends imply (all other things being equal) that the pool of savings and demand for investment vehicles will be increasing in the developing world in coming decades as it diminishes in the developed countries.

It is likely that a large portion of the projected increase in savings in developing countries will find its way into bank deposits, bonds, or direct equity investments rather than into portfolio equities. Many developing countries, however, have national pension systems in place (or arc developing such systems) that allow individuals to allocate some of their savings to equities. These include the provident funds of Singapore, Malaysia, and Hong Kong, as well as the private pension systems that operate in tandem with public systems in every major Latin American country. The existence of these pension systems increases the likelihood that the projected increase in savings in developing countries will result in an increase in demand for domestic equities. Latin America’s pensions provide a case in point. As of year-end 2000, private pension funds in Latin America had $175 billion in assets under management (AUM), an estimated 19.9% of which (or $28.7 billion) was invested in equities. All told, equities held by those pension funds account for 7.6% of the market capitalization of the region’s equity markets, and over 10% of market capitalization in Argentina, Brazil, Chile, and Peru. In some countries, notably Brazil, private pension funds have become the most important source of domestic long-term capital. SSB bank analysts expect AUM in Latin America, which have been growing at an exponential rate, to exceed $885 billion by 2015. If 30% of those assets have been invested in equities by that time, these investors will be holding over $265 billion in equities. To put this amount in perspective, the total market capitalization of Latin America’s stock markets today is about $330 billion.

Growth of Institutional Investing Should Lead to Improved Corporate Governance

One of the major risks in the emerging markets is that an investment in a company can be undermined by actions that exploit weak corporate governance mechanisms. Investments can be damaged by poor disclosure of ownership structures and interests, the disenfranchisement of minority shareholders, a lack of timely reporting, dubious accounting practices, and asset stripping and the diversion of profits to parallel structures. While corporate governance in the emerging markets often leaves much to be desired, the trend toward increased institutional investment in those markets should bring about improvements over time. As a result, the risk premium for poor corporate governance should fall, providing a boost to stock markets.

Institutional investors - foreign as well as domestic - already have a strong presence in many emerging markets. Institutional and foreign investors, for example, account for about 40% of the trading volume on the Sao Paulo exchange (financial institutions account for most of the rest). The demographic shifts under way in the emerging markets should increase the presence of domestic institutional investors in local equity markets further. As that happens, institutional investors are likely to demand improvements in corporate governance, which should lead to increased attention to enhancing shareholder value and a rise in equity values.

The United States provides an example of how this process may unfold. In the 1980s, hostile takeovers and leveraged buy-outs (LBOs) were common, as outsiders and managers sought to unlock value in poorly governed corporations. In recent years, however, hostile takeovers and LBOs have become far less common. According to a recent study by Bengt Holmstrom of the Massachusetts Institute of Technology and Steven Kaplan of the University of Chicago, the fraction of contested takeovers in the United States has fallen to 10% today from 40% in the mid-1980s. 2 This has occurred, they believe (and we concur), because corporations now pay more attention to shareholder interests. Demographic changes in the United States increased the portion of funds under institutional management to 50% today from 30% in 1980. Managers of those institutions have assumed the role of permanent shareholders and begun demanding better corporate governance and efficiency. So have corporate directors, who have increasingly linked executive pay to performance through options. The increased efforts to improve shareholder value have resulted in a massive restructuring of U.S. industry and, together with technology-enhanced improvements in productivity, contributed to the bull market in U.S. equities of the 1990s.

While it may be a stretch to suggest that the emerging markets will replicate the U.S. experience in the 1990s merely by improving corporate governance, there is at least little doubt, in our opinion, that the upside potential for such improvements in the emerging markets is large. There are signs, moreover, that the demand for better corporate governance in the emerging markets is on the rise. International organizations and individual governments have taken the lead in establishing guidelines for good corporate governance. These include the OECD's Principles of Corporate Governance and the World Bank’s Corporate Governance: Framework for Implementation. International organizations and governments; have in recent years sponsored several roundtable discussions among regulators, stock exchange officials, and investors in Asia, Latin America, and Eastern Europe to discuss how corporate governance might be improved. Bovespa, the Brazilian stock exchange, is working with domestic and foreign institutional investors to establish the Novo Mercado, a listing segment for companies that agree to abide by corporate governance practices and disclosure requirements that go beyond those required by Brazilian law. And finally, Standard & Poor’s is now issuing corporate governance scores, which express Standard & Poor’s opinions about the extent to which a company has adopted and conformed to codes and guidelines of good corporate governance practices that serve the interests of the company's shareholders and creditors. Investors may find these scores to be useful in judging the quality of a company’s corporate governance, just as they currently find the rating agencies` credit ratings useful in judging the ability of firms to meet their debt obligations.

In the midst of the downturn in global growth and turmoil in the emerging markets, it is hard to focus on matters such as demographic change, increased savings, and improved corporate governance. In our view, however, it is just these factors that will determine whether the upward trend in equity prices in emerging markets evident between 1987 and 1997 (and missing since then) will re-establish itself. In our opinion, it will be that trend, rather than cyclical fluctuations, that will ultimately determine the attractiveness of the emerging markets asset class.

SALOMON SMITH BARNEY PORTFOLIO STRATEGIST

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2 Bengt Holmstrom and Steven N. Kaplan, "Corporate Governance and Merger Activity in the U.S.: Making Sense of the '80s and '90s," National Bureau of Economic Research, Working Paper No. W8220 (April 2001).

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