Rather than worrying whether the recent emerging market equities rally is sustainable, investors who believe in a long-term growth story should not attempt to time the unpredictable, finds Joseph Mariathasan

Erik van Dijk, managing director of Lodewijk Meijer, recounts the results of a straw poll of Dutch pension funds' attitude towards emerging markets (EMs) at a recent roundtable. Half were anxious to invest more, regarding the worst losses as behind us and the longer-term story as very powerful. The rest saw EMs as inherently too risky and volatile to invest in. The story recounts the dilemma all investors face with EMs - the structural transformation in these economies seems unstoppable, while the stock markets can seem unmanageable.

"It's remarkable that Brazil and Turkey have both brought interest rates down to single digit levels during this crisis to stimulate their economies, and with only marginal impact on their currencies," as Mark Gordon-James, a fund manager at Aberdeen Asset Management points out. "This has never been possible before and it is a signal these countries have been de-risked. Both economies are likely to see a return to growth in 2010 as a result."

Even the effects of the current financial crisis have been more muted than the worst fears. Maarten-Jan Bakkum, global EM equity strategist at ING Investment Management, points out that the G20 decision to boost the IMF's support to countries in need took away a lot of risk, particularly in Eastern Europe, where investors are now much less concerned about currency and interest-rate risks.

But despite these macro-economic factors, investing in EM equities has always been a volatile experience - not least thanks to a lack of a diversified domestic investor base that can provide liquidity when foreign investors choose to pull out, for reasons that often have nothing to do with long-term fundamentals.

"There did seem to be the most indiscriminate sell-off last year as a function of de-leveraging, and China and Russia were particularly highly-leveraged plays," says Richard Gower of Armajaro, a commodities specialist that recently launched a new EM fund. "As result, everything, regardless of underlying value, just got trashed. If we can pick our way through that with the huge amount of experience that we have, we should be able to find some nice assets."

Bryan Collings, managing director of Ignis Asset Management boutique Hexam Capital, points out that the Russian stock market was at one stage 80% owned by foreigners; one reason why it fell over 70% last year was because there are no domestic transmission mechanisms between savings and investment.

Top-down or bottom-up?

This may also go some way to explaining why EM stocks generally have much higher correlations with their country indices than with the global sector indices. As a result, top-down macro-economic analysis can play a significant part in generating alpha. With a universe of many thousands of stocks to choose from, deciding on the appropriate mix between top-down and bottom-up is a fundamental decision fund managers need to make.

The improvement in the data available has given impetus to quantitative approaches using, as AXA Rosenberg does, the same processes as those applied in developed markets. While AXA Rosenberg, according to European CIO Gideon Smith, has a purely bottom-up approach with no country or sector bets, not all quantitative managers eschew top-down views. GMO, for example, combines its stock-selection models with a top-down, country-selection model.

Having centralised teams of fund managers in one location can have its advantages in incorporating top-down analysis. Hexam, with just four investment professionals in London, blends country analysis with stock selection to construct concentrated portfolios of about 35 positions, boiled down from an ‘ideas list' of 120. But centralising investment management arguably makes it more difficult to delve deeply into local markets. BNP Paribas Asset Management got round this issue by undertaking a series of 10 joint ventures in EMs across the globe, giving access to 150 investment professionals, according to Martial Godet, head of new markets investments.

"These teams run single country funds and produce model portfolios that are sent to London and Paris-based global emerging market teams, who undertake the asset allocation across countries and regions, with 70% of the alpha generated coming from stock selection," he says.

Old Square Capital, an EM fund of funds, takes this idea even further by investing in a portfolio of local and regional managers with a heavy over-exposure to frontier markets and second-tier stocks complementing the mainstream managers. Another variation is Nomura's, which takes country, but not regional, bets in its global EM strategy. It has three independent managers running Asia, EMEA and Latin America. With markets experiencing volatility at a level that no manager can keep up with, as David da Silva of Nomura Asset Management explains, "whilst each [manager] experienced periods of underperformance over the past year, they were uncorrelated, so that overall our strategy was well diversified; highlighting one of the key benefits of a regionally-focused global strategy."

Van Dijk has the view that both top-down and bottom-up approaches are essential ingredients of an EM strategy, but the trade-off varies tremendously with the country in question. The more volatile the markets and the less developed they are in terms of sector distribution, size of firms, regulatory framework, and so on, the more important the bottom-up analysis. Moreover, as da Silva points out, there are fewer analysts covering the companies in less developed markets, enabling specialists to generate an information advantage.

"But in the end, one has to create a well diversified, risk-controlled portfolio as well," argues van Dijk, "and that is where the top-down aspects come in."

For the BRICs and other more developed emerging markets, he sees 75% top-down and 25% bottom-up as a suitable mix; 50/50 for the rest of the MSCI EM Index and 25/75 for frontier markets. But, as he explains: "The calamities that can be caused by improper diversification do, of course, increase with the level of volatility. As a result, the 25% exposure to top-down analysis in frontier markets is, relatively speaking, as important as the higher allocations given to the more developed emerging markets."

Domestic demand versus exports

Clearly, global EM has not seen the ‘decoupling' from global markets that many had argued was the key attraction. But as Mark Atherton, head of global EM at Aviva Investors, says: "The whole point of emerging markets is that they are becoming more integrated into the global economy."

Damage to major export markets has had profound implications for the future growth models of many EM economies. However, as Atherton explains, there are clear distinctions to be made between groups of countries. While the vast majority are able to reduce interest rates (historically they have had to raise rates in a crisis), some, like China, are also able to stimulate domestic demand. On the other side, small open-trading nations like Hong Kong, Singapore, Korea and Taiwan have seen the exports they depend on collapse, leading to falls in both their currencies and stock markets. There is a final group of countries with less flexibility, mostly in Eastern Europe, which in many cases have over-leveraged economies with large foreign currency debt.

Overall, domestic demand has been, and will continue to be, the key driver of EM growth. There is also much more intra-emerging market activity going on - exemplified by the recent inter-governmental agreement which will see Russia pump its oil into China for the next 20 years in return for $25bn in loans to Transneft and OAO Rosneft. "We're going to see more an more of these deals," says Michel Danechi, manager of Armajaro's new EM fund.

Gordon-James sees several supportive factors: corporate and household balance sheets are relatively strong; fiscal management is now mostly sensible; the inflation dragon has largely been tamed and interest rates are at historic lows; and demographics are supportive. "Brazil, India, Mexico, Turkey and Egypt are all in a surprisingly good position, as we speak."

China is becoming the pre-eminent example of domestic demand-led growth. While the government has been flooding the marketplace with liquidity and developing domestic stimulus through large-scale infrastructure projects, a fundamental cause of the global mis-alignments has been the propensity for Chinese consumers to save, indirectly financing the US consumer, largely thanks to the lack of social security systems that would enable workers to be assured of provision for old age and illness. China is tackling these issues and over the next few years the requirements to save should be reduced, releasing pent-up consumer demand.

In contrast, Gordon-James would place Taiwan, Korea, Russia, sub-Saharan Africa, the Gulf and some of the Central European states in the "export-led" category. Hydrocarbon and mineral exports are central to Russia's growth story, so while commodity prices remain under pressure, so will Russia's economy. "What makes it even tougher for Russia," he says, "is the unhealthy state of the rest of her economy: the banking system is structurally weak, the corporate sector is quite heavily indebted in parts, currency mismatches remain an issue, productivity in non-commodity industries is low, and the government provides an unpredictable backdrop. So while valuations look superficially attractive, from a global perspective there are better opportunities elsewhere."

In terms of manufactured goods, Asia, and in particular Taiwan and Korea, are the most exposed of the export-led markets. While the emerging world itself now accounts for around half of Asia's exports, shrinking demand from the developed world will make for a tough environment for at least the next year, especially as many industries added substantial capacity in 2007-08. In contrast, Gordon-James argues that contrary to a widely-held misconception, Brazil is not heavily dependent on exports; in fact net exports contribute around 15% of Brazil's GDP, similar to China: "We see both of these countries, along with India, as relatively defensive via-a-vis a weak export environment."
Is the rally sustainable?
EMs are currently caught between two extremely powerful but opposed forces: the precipitous drop in exports and the enormous amounts of money being pumped into the global economy. Not surprisingly, the rally from the lows seen in October 2008 has left investors confused. BNP Paribas Asset Management, according to Godet, has been repositioning its portfolios away from defensive stocks towards the cyclicals that are likely to outperform as economies recover. In contrast, Alex Tarver, GEM specialist at Halbis, part of HSBC Global Asset Management argues: "We are probably at the top of a very broad trading range overall. There are a lot opportunities now, but not as many as a year ago."

EM is highly susceptible to large market moves on the back of short-term news as foreign investors switch assets around. "Clients say to me, ‘Bryan, when do you think EM volatility will drop?'" says Hexam's Collings. "And I say, ‘You tell me - I'm lower on the food chain. You guys are the ones putting money in and out. Every time there's a bull market you put money in and it's too late, then you take it out again'." No one knows whether the spring rally is sustainable and as Mark Mobius, executive chairman and manager of the Templeton Emerging Markets Investment Trust argues, the only thing we can be sure of is that there will be many ‘W' shaped movements for some time to come. The issue for Tarver is "if the emerging markets dip, will they drop to the same levels as last year? I would expect any falls would not be as steep."

Behind the stock market volatility of course, is the long-term structural economic story that underpins EM growth - the rise of the domestic consumer that can offset a reliance on exports. And while there were massive outflows in 2008, Godet estimates that as of May, around a third of that had been returned, mainly via ETFs. Perhaps investors who believe the long-term story should summon their courage and not attempt to market time the unpredictable.