x Abu Dhabi, UAESunday 21 January 2018

Established markets seen as too developed to succeed

Once upon a time, developed economies were a sure bet for investors. But emerging markets are giving them a run for their money.

Compared with the developed world, emerging markets are doing relatively well. China’s foreign-exchange reserves have doubled to US$3 trillion (Dh11tn) since the financial crisis began. Qilai Shen / Bloomberg
Compared with the developed world, emerging markets are doing relatively well. China’s foreign-exchange reserves have doubled to US$3 trillion (Dh11tn) since the financial crisis began. Qilai Shen / Bloomberg

A decade ago, emerging markets came with a severe wealth warning. There were seen as volatile, politically risky, financially unstable, hyperinflationary and prone to extreme bouts of boom and bust.

You might get rich investing there, provided you got out soon enough. If you didn't, you could lose everything. That was the price you paid for trying to make fast money out of a hotchpotch of developing economies, former colonies and fledgling democracies.

Anything could happen in emerging markets, and it often did. Like, say, the 1994 Mexican peso crisis, the 1997 Asian financial crisis and the 1998 Russian financial crisis. Private investors might put 2 per cent or 3 per cent of their portfolio there, just for the sake of it, but mostly, it was safer to stick to the developed world.

The US, the UK and Europe were a much more solid bet. They were healthy, established democracies, with low levels of corruption, strong corporate governance and a host of proven businesses and brands. The West was the best.

True; developed countries weren't immune to the highs and lows of the business cycle, and suffered the odd catastrophe such as the dotcom collapse, but on the whole, they were considered fundamentally sound.

Then came the credit crunch and everything changed. Suddenly, the West was drowning in debt. Its bankers were exposed as reckless speculators, its housing markets a sub-prime scandal, its politicians feeble and often corrupt. In the UK, for instance, scores of British MPs were found to be routinely fiddling expenses. Several have been jailed.

Volatile, politically risky, financially unstable and prone to extreme stock market swings? Today, that describes the developed world. By comparison, the major developing economies are a picture of fiscal rectitude.

While the US is US$14.3 trillion (Dh52.5tn) in debt and its prized AAA credit rating under threat, China's foreign-exchange reserves have doubled to $3tn since the beginning of the financial crisis, and Brazil, Russia and India have combined reserves of well over $1tn.

And while the US and UK allowed their property booms to run out of control and are now trying to inflate away the subsequent debts, China is rapidly tightening in a bid to curb its property bubble and stop the economy from overheating. It has learnt from the West's mistakes.

As with all revolutions, it takes time for attitudes to catch up. Analysts and independent financial advisers still routinely warn their clients that investing in emerging markets is still high risk. But slowly, a new truth is dawning.

The western sovereign debt crisis means that many emerging nations are now less volatile than the developed countries they wish to emulate, according to Max King, the portfolio manager at Investec Asset Management.

"There is an underlying presumption that developed markets are low risk and emerging markets are high risk," he says. "But looking at some of the so-called developed nations in Europe, it is absolutely ludicrous to assume they are not risky. If you look at the numbers for Japan, the UK and the US, then it is easy to see structural problems with those economies, too."

If many developed economies are held in undeservedly high esteem, some emerging economies are completely misunderstood. "Many analysts bracket Singapore among the emerging nations, but it is already a highly developed, market-based economy," Mr King says.

Investors need to cast off their old prejudices and preconceptions about developing and emerging, West and East, and base their decisions on the fundamental economic strength of each nation, Mr King says.

It is a compelling argument. The West doesn't just have a massive public and personal debt burden; it also has to face the challenges of an ageing population, unaffordable pension and state benefits, and shrinking tax receipts. Emerging markets such as India, Indonesia, the Philippines and Malaysia boast youthful demographics, minimal personal debt and low state benefit obligations. So who's risky now?

Other fund managers are waking up to the new reality. Bryan Collings, the managing partner of fund Hexam, also argues that emerging markets are less risky. "I fail to see how you can generate growth and earnings without having a pot of savings to do it with," he says. "And we know where the savings are in the world."

This isn't a temporary reversal. "Emerging markets in the long term? Far safer," Mr Collings adds.

If these two fund managers are right, we are witnessing an incredible about-turn. Latin American juntas and narco-states have been slowly replaced by fragile, but functioning, democracies. The Chinese and Russian communists have become capitalists - up to a point. The West discovered outsourcing and India discovered IT.

The BRICs (Brazil, Russia, India, China) have captured all the headlines and with good reason. China is now the world's second-biggest economy and could overtake the US as early as 2017.

India's middle class numbers hundreds of millions. Russia has overtaken Saudi Arabia as the world's biggest oil producer. Brazil is now one of the top 10 global economies.

At the same time, many western countries are effectively bust, especially on the fringes of the eurozone, says Mark Dampier, the head of research at Hargreaves Lansdown, the UK's largest independent financial adviser. "If you're a bond investor, why would you lend money to a country that isn't going to pay it back? You'd be crazy. I've been amazed that Greece has been able to borrow money at all. Those days are over. Investors would rather lend to emerging markets because they have stacks of money to repay you."

But investors shouldn't abandon the West altogether. "There is a big mismatch between the state of a country's finances, and the profitability of its leading companies. The US, the UK and Europe still have scores of world-class companies. If you invest in them, you should be fine, especially since many will benefit from emerging market growth," Mr Dampier says.

Emerging markets are in danger of becoming victims of their own success, says Clem Chambers, the founder of the stocks and shares website, advfn.com. "You have companies trading on valuations of 30 or 40 times earnings. As a general rule, 15 times earnings is thought to represent fair value, so these look overvalued. It won't take much to knock them back."

They also remain more volatile. "In the credit crunch, stock markets in the developed world took a big hit, but emerging markets were absolutely smashed. They have rebounded faster because risk works in both directions, both up and down."

Emerging markets have made huge economic strides over the past decade, but they remain politically much more risky than the West. "We have seen apparently stable regimes in the Middle East deposed by sudden revolutions. The Chinese government has been clamping down on dissent. The US, UK and Europe have their problems, but I can't see any revolutions happening there," Mr Chambers says.

If emerging markets are now less risky, might they also be less rewarding? Possibly. At the beginning of this year, investors started pulling their money from the BRICs and heading West.

Emerging markets have had a fantastic run, but Mr Chambers says the party could be coming to an end. "The BRICs are starting to look expensive now. You shouldn't expect dramatic returns over the next couple of years. In fact, they are likely to emulate the West. Markets soared in the 1980s and 1990s, but have remained more or less flat over the past decade, although with plenty of volatility. The BRICs look set to do the same."

So how much of your portfolio should you invest in developing countries? The answer partly depends on personal factors, such as your attitude to risk, but traditionally, IFAs recommended their clients should invest no more than 5 per cent or 10 per cent of their wealth in emerging markets. "You can probably up this to around 20 per cent, as emerging countries make up a greater share of global wealth. But don't deceive yourself into thinking that these countries are low risk, because they aren't," Mr Chambers says.

Risk is everywhere these days, says Jeremy Batstone Carr, an investment analyst at stockbrokers Charles Stanley. "Europe has massive sovereign debt problems, the US has hit its debt ceiling and the UK is flirting with recession, but emerging markets also have their problems. China, Brazil and India are desperately trying to cool their economies. If the US launches another bout of quantitative easing, as I suspect it will, their inflationary problems could get worse. Right now, I wouldn't recommend investors take on any undue risk, either in the East or West. We are remaining defensive, and I suggest that you do too."

Perhaps the big shock isn't that emerging markets have become less risky places to put your money, but that developed markets have become so much more dangerous.