Emerging Markets: Shifting from Periphery to Core

Those in attendance at Morningstar's first ETF Invest Conference were treated to David Semple's insights into the emerging-markets space. A recognized veteran, Semple serves as head of Van Eck's emerging-markets team and manages the Van Eck Emerging Markets (GBFAX) and VIP Emerging Markets funds.

Not an Opportunistic Asset Class
In his opening drive, Semple explained that, contrary to popular belief, emerging markets do not afford investors an opportunistic asset class. While emerging-markets investment vehicles have traditionally been relegated to satellite-holding status, the data provide a strong case to the contrary.

Global population is most heavily concentrated in the emerging-markets regions, and Semple noted that at 37%, emerging markets account for an accordingly large share of the global economy. Commodities in these markets are no longer constrained by demand-side drivers, as emerging markets have grown to command a majority share of global resource supply in nearly all commodities sectors.

Semple posits that despite growth in the space, the MSCI still maintains a 12% emerging-markets weighting, a marked underrepresentation by even conservative global gross domestic product, or GDP, estimates.

The recent economic downturn has seen a strangulation of growth across the broad market. Many have adopted an outlook of constrained economic growth as the "new normal." According to Semple, such circumstances should only bolster investor interest in emerging-markets assets, as they have maintained their growth premium throughout the tumultuous financial storm of 2008-09.

On the supply side, the palette of emerging-market investments has consistently expanded over the last 20 years. Many nations have only recently become investable. Semple notes that only two decades ago, Taiwan, China, Korea and India were virtually inaccessible.

Demand for those investments has been expanded as well, as a much wider range of market players have entered the space. The life insurance industry, private banks, high-net-worth management firms and pension funds have all thrown their hats into the emerging markets for the first time.

Equities in emerging markets have traditionally traded at significant discounts to their developed-markets counterparts. Semple added that given the sustained broadening of the market, he expects the situation to amend itself. The trend of expansion in the emerging markets seems to indicate the stemming tide of opportunistic outlook on the space. Historically, those interested in emerging-markets investment took an all-in or all-out approach, but Semple feels that the emerging-markets development argues for a more subtle core allocation approach to the space--one that the general investing population has yet to embrace.

Emerging Markets: Sovereign, Corporate, and Individual
Semple transitioned to a quick but more refined discussion of the emerging markets overall. Sovereign debt in emerging markets is in much better shape than years past, and Van Eck is enthusiastic about its long-term volume. They are congruently optimistic about emerging-markets currencies.

While U.S. corporates are in good shape, Semple notes that emerging-markets corporates are doing better. Companies domiciled in emerging-markets regions tend to provide relatively low payout ratios, due in large part to regionally and culturally perpetuated ego and legacy issues among high-level executives. The repercussions of such circumstances have tended to be prolonged capital expenditures cycles, but corporate balance sheets for emerging-markets companies are shining none the less, as cash flows have continued to exceeded capital expenditures and dividends.

Semple was quick to nip any talk of an emerging-markets bubble in the bud. He noted that while forward estimates for the space have ticked up a bit, they are not out of line. Emerging markets maintain little to no leverage on the sovereign, corporate, and individual levels. As Semple explained, until recently most of these regions have had no access to debt or, in many cases, banks. In either case, Van Eck views much of the emerging-markets space as relatively cheap and low risk.

Country Outlooks
At the end of the day, investors are interested in one thing--identifying areas of profitable opportunity. Semple outlined several countries and regions in which Van Eck had identified promising investment potential.

The markets of Southeast Asia are "ripe" for investment, as Semple describes it. They have done very well on both stock and currency sides of the market. Given their increasingly stable political situations and low interest rates, Van Eck views investment here in a warm light. That said, Semple is not overly enthusiastic about China, though he foresees a soft landing as the nation takes measures to rescind excessive stimulus funds.

Semple has a positive outlook on Russia, barring the hydrocarbon plays that generally typify investment activity in the region. As he sees it, the Russian energy sector is constrained by standing tax policies and uncertain political treatment, though other sectors look promising.

Brazil is one of Semple's favorites. The middle class continues to grow with business activity. That said, he refrains from drawing parallels across the whole of Latin America. Given the recent drug related violence and sociopolitical turmoil, Semple is wary of investment of Mexico. He notes that the nation's economic activity tends to move in lock step with the United States. Until we see a strong U.S. recovery, investment in Mexico should be reconsidered.

The Bottom Line: Plain and Semple
Semple notes that the emerging markets are held hostage by Wall Street fears of stalled growth, deflation, and developed-economy sovereign default in the short run. As emerging markets continue to open themselves to the global economy, however, their middle classes grow and their currencies look to appreciate. Moving away from the traditional mercantilist systems pervasive in emerging markets may pose difficulties as internal growth drivers need to be developed, but Semple expects the traditional boom-and-bust cycle to subside.

ETFs allow investors to tap previously inaccessible emerging markets, but Semple advises against overlooking equity- and nation-specific risks. Many of the largest holdings in emerging-markets indexes are government owned and disregard the interests of minority shareholders. Though the various emerging markets are often collectively tossed into the all-inclusive and ambiguous "emerging-markets" basket, each operates in its own space with varying and unique drivers.

Semple sees ETF trading on the local level increasing and notes that, within emerging markets, large inflows are useful as an indicator of market tops. He doesn't find valuations in the space to be challenging or compelling, rather interesting, and predicts that emerging markets will maintain growth premium in all but the worst scenarios going forward.