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By Holly Cook | 12-07-2010 02:43 PM

Invest in Emerging, Not Submerging, Markets

Schroders' Allan Conway tells Morningstar U.K.'s Holly Cook why he believes that emerging markets are less risky than developed markets right now.

Holly Cook: For Morningstar, I am Holly Cook. Joining me today is Allan Conway. He is head of Global Emerging Market Equities at Schroders.

Allan, thanks for joining me.

Allan Conway: Pleasure. Thanks.

Cook: So, Schroders' emerging markets team manages $26 billion of assets in the region. You've got funds in emerging markets, in BRICs, you are about to launch a frontier markets fund. Can you explain terminology-wise, what are the differences between 'developing' markets, 'emerging' markets and 'frontier' markets?

Conway: Sure. There is actually no accepted definition, but the starting point tends to be on GDP per capita. So, very simply, economies with a GDP per capita above about $11,000 would be developed, between roughly $1,500 and $11,000 would be emerging, and underneath that that would be frontier. Having said that, there are lots of exceptions and that comes down to openness of markets, the ease of moving money in and out and other regulatory requirements. So, it is not an easy answer, but broadly speaking it's based on degree of development.

Cook: So, I guess the key question is, why would investors want to invest in emerging markets at all?

Conway: I'd almost turn the question the other way, why on earth would you want to invest in what are now called developed markets? I'd rather – they are really the dinosaurs of the economic world. I think you could call the world today as split between emerging and, if you like, 'submerging'.

The developed world is now hindered by a massive degree of debt—the ball and chain around the necks of these economies is going to take them years to get out of that. They have got adverse demographics. Japan, as we know, is shrinking in population. Europe, the U.S. are looking quite similar. They really are yesterday's story. In a good year you might see these economies jump for joy if they are growing at 2.5%, more likely it's going to be less than that.

Today emerging markets account for something like 65% to 70% of growth in the world. Economic power is clearly shifting eastwards. The arrival of China and India, 2.5 billion people, that's dramatically changed the economic landscape and the strong economies today, the economies that dominate global growth, are the emerging economies. So I think the question is why on earth would you want to invest anywhere other than these economies?

Cook: Given the dichotomy that you described, emerging markets were actually already a fairly popular destination for investors' assets, and increasingly so recently, which has obviously led to talk of overheating. What's you take on that?

Conway: There are some issues there—people are getting concerned about inflation in emerging, but we are way, way off a bubble. One of the things I have just put together in my presentation is a little cartoon of this strong body-building fellow blowing up a balloon and the balloon is starting to inflate, but it's a long, long way from bursting. In fact, as he is blowing up this balloon, it probably won't burst until about 2012. It is going to take at least a year to get this balloon blown up enough to bursting point.

I have got opposite him this wizened old man, who just hasn't any air in his lungs at all to remotely blow the balloon up. There are various arrows coming in at these balloons; the little old man, not only is his balloon not blowing up, but if he were to get any air in it, it will be burst pretty quickly because these arrows—marked by double dip and euro crisis and massive debt—are going to ensure there is no air that gets into that balloon.

There are some balloons [arrows] heading towards the emerging, this big strapping fellow, most of them are going to miss—things like double dip and debt, these are issues coming from the submerging world, as I call it. The only one issue in the emerging world that people are concerned about is inflation—we think those [concerns] are overdone. But today emerging markets are on a prospective P/E of 11.5 times—that's nowhere near bubble territory. Ultimately, it's quite likely we'll end up in a bubble; there's massive liquidity coming into emerging, investors really now deciding that you've got to have strategic exposure, not just tactical exposure to emerging. So I think in the end we'll see a bubble, but I think that's a story probably for 2012. When you see a prospective P/E of 17 times, 18 times and various other indicators where you've got excessive overvaluations, that's the time to get out. Between now and then, there's a lot more to go for.

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