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Emerging Markets Graduate During the Crisis

Jason Stipp

Jason Stipp: I am Jason Stipp for Morningstar. It's International Investing Week on Morningstar.com, and today we're focused on the emerging markets, an endearingly popular area with investors based on Morningstar's fund flow data.

I am joined today by Gonzalo Pangaro from T. Rowe Price Emerging Markets Stock Fund, an Analyst Pick in the emerging markets category, and he is here to tell us a little bit about the lay of the land and what he is seeing in emerging markets.

Gonzalo thanks so much for calling in today.

Gonzalo Pangaro: Thank you for taking the time.

Stipp: First question for you, Gonzalo, in Morningstar's fund flow data, we've seen that the emerging markets continue to be popular with investors. Investors are putting a lot of their money there. I was wondering if you could give a broad take on your sense of valuations in emerging markets. Certainly, we saw on Friday there was a bit of disruption in China. So, we're wondering, do you think that the emerging markets broadly could be due for a cool-off?

Pangaro: I think in the short term, I wouldn't be surprised to see a correction in emerging markets, but we continue to be constructive over the medium term. Emerging markets particularly during the global financial crisis, they really graduated, they proved that all the reforms which have been taken over the last 10, 15 years with fiscal prudence, controlling inflation, switching back into domestic currencies, and having very solid and plain-vanilla banking systems, they were really well prepared for the crisis.

In terms of valuations, valuations are still reasonable. We have come up a long way, but we're still trading now in line with developed markets when we look at the last 20 years, valuations are still in line with the median for the last 20 years.

What I have seen, which I think is very interesting, is a divergence in valuations, some less well run companies trading at still very low multiples. A few Russian names are examples of that, and other well-run companies, which have executed year-in, year-out, particularly in the consumer sector, trading at roughly 20 times, but we think many of these companies will grow into those valuations through strong earnings growth.

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Stipp: As you are looking at your portfolio, and I know that your folks are looking from the bottom up for individual stocks. You mentioned a few areas in your answer there, are you finding that in some areas of your portfolio, you may be looking to trim or they may be becoming more fully valued, while other areas of your portfolio perhaps still look like they may have some room to run, and also do you find any trends to where you're finding values out there in the marketplace, either by region or perhaps by industry?

Pangaro: When you look by industry, we have our higher investments on relative weights versus the index in the domestic sector, so this trend of very strong demographics, urbanization, rising real wages, we still find good consumer names to play that. We have trimmed a few of these names as they've reached our target prices, if the investment case doesn't change, we start trimming, but there are still several which we think are attractively valued, and they have been coming with very strong earnings results.

The other sector in which we find interesting opportunities still is in the material sectors, particularly a few miners, which are growing productions at a very low cost, very strong financial position, such as Antofagasta, which is a Chilean copper producer and a large holding in the fund.

When we look from a regional standpoint, we still like the BRICs, and we have been adding to China with some weakness on concerns about tightening in China today. When you add China and Hong Kong, it's a decent overweight for us and roughly 20% of the portfolio.

Stipp: You touched on this briefly in your first answer, but I want to get your take from a global perspective. As you said, a lot of the fundamentals in the emerging markets look pretty attractive relative to some of the fundamentals in developed markets, especially with some of the debt loads that you see in some of the more developed markets. Also, as you mentioned, the domestic populations in emerging markets are really starting to become a growth factor. How would you characterize the fundamentals overall that you're seeing in emerging markets compared with what we have been seeing recently in some of the developed markets?

Pangaro: I think, fundamentals are quite strong, and as I mentioned earlier, emerging markets really graduated during these crisis and looking forward, they are in a much better position with underleveraged governments, companies, and consumers. Loan penetration in many emerging economies, mortgages to GDP in Brazil is 2%; Russia is a similar ratio. ... All these factors are very underdeveloped, so we still think there's a lot of potential.

What we are seeing is a polarization in emerging markets. There's a few countries with still large fiscal and current account deficits, and we think growth in those countries is going to be less significant going forward, and it's been heading into the crisis. And examples of those are South Africa and some of the Eastern European countries, such as Czech Republic and Hungary.

Stipp: Sort of a follow-up question on that point. As you said as the emerging markets are growing up, I think that especially through the financial crisis, the issue of correlations has been top of mind for a lot of investors. Do you think that if the emerging markets are becoming closer to growing up and developed market status that we may see less diversification benefits with the emerging markets than we have in the past?

Pangaro: That's a good and fair point, and correlations when you look over the last 10, 15 years, they have gone up, and were particularly high during the crisis. In emerging markets, there was a stampede for the exit from non-dedicated investors, and clearly any diversification benefits didn't work out in the fourth quarter of 2008. I think even though correlations have gone up, there is still a benefit and diversification benefit from investing in emerging markets.

Stipp: Last question for you. If you had to characterize what you would identify are some of the risk factors in emerging markets, what things would top your list as the things that you are keeping a closest eye on and monitoring very closely?

Pangaro: I think, the key risk is this global imbalances and potential from it. You have the U.S. and the developed world in general with very loose monetary policies. China reluctant to let its currency appreciate--recently it started to move, it's up 3% year-to-date, but that's less than what's needed today. And with very loose monetary policy, all that capital will make it into other emerging economies, and there's a potential for bubbles.

The encouraging thing is that this time around, the emerging markets have been reluctant to receive this capital, while 10, 15 years ago, they would have been very welcoming of it. So, you have Brazil, Thailand, Indonesia, trying to implement taxes or measures to stop this capital [which could] create bubbles in the domestic markets.

So, that's the key – that's the key risk, and related with that and the weakness of the dollar and higher commodities prices is inflation. Inflation had been very subdued in emerging markets, but over the last week or so, whether it's Brazil or China, we've seen some inflation numbers which are starting to be concerning, and that's something we're keeping a close a eye on.

Stipp: Gonzalo Pangaro from T. Rowe Price Emerging Markets Fund, thanks so much for calling in today. I appreciate your insights.

Pangaro: Thank you very much.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.