Emerging Markets - Are you sufficiently exposed?

Pounding the point home, once again.

I have written a great many times (e.g. 1, 2, 3, 4 or all, 5) since this blog started over four years ago, about the need for any forward-looking, growth-oriented investor to have a very serious weighting in emerging markets. A recent article in the Financial Post, highlighting information from Goldman Sachs Global Economics Paper No. 204, makes the point worth repeating, once again.

They point out that the emerging markets now total some 31% of the global stock market capitalization, and suggest that this will expand to 55% by 2030. Is that shocking? Hardly. According to the OECD, a global club of rich countries, emerging markets already have 49% of the global GDP, on a purchasing power parity basis; and they appear slated to continue growing rapidly. Is it a surprise to think that their stock market valuations are slated to follow their growth?

What is shocking, is that against that, Goldman Sachs estimates that developed market investment funds hold just 6% in emerging market equities, out of their total equity allocation. They believe this will rise to 18%, by 2030. In other words, if you are a typical rich country investor, a peek behind the curtain of investments that YOUR investment advisor has gotten you into, would reveal that you are sitting at just 20% the emerging market exposure you should be at, assuming you simply want to mirror the world economic powers (e.g. 6% divided by 31% = 20% exposure). By 2030, the situation gets somewhat better, but your exposure would still be wildly low, compared either to world GDP then, or emerging market stock market capitalizations.

If you wanted to simply mirror global market returns going forward, then seriously underweighting one of the two most easily visible growth investment themes going forward sure isn't the way to do it. If you wanted outsized returns, then you'd likely seek even more participation in rapidly growing economies, assuming you have decent entry points, e.g. valuations not stretched. (Are they currently too high? Not in my book. They are trading at an average PE ratio of just 12, according to the Financial Times, which compares to a PE on the S&P 500 of 14.7).

The other thing to know here, is that the emerging markets are no longer the wild west. They have solid economic principles they are managing their economies on, and populations of great savers (oh, if only the western world were so lucky now!). This makes it pretty easy to suggest that their stock market volatility is going to continue to move down, especially compared to the overleveraged and overspent rich countries.

If you are a growth investor, go wake up your investment advisor, and demand he or she explain exactly why your emerging market exposure is so darn limited.

Disclosure: Participant in the emerging markets theme via DEM, DGS.

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Emerging Markets

I was recently forwarded a paper written by Goldman Sachs reseachers in October 2003 relating to the potential of the BRIC emerging economies. I have written on emerging market potential outperformance many times (and here, and here too) before.

The paper projects that, given favorable growth regimes in those countries, that these economies will be one-half the size of the G6 by 2025, and larger than them, as measured in USD, by 2040. In fact, the world's largest economy in 2041 is predicted to be China.

The paper has obvious implications for any forward-looking investor. They also suggest that one expectation is that average currency appreciation for BRIC nations will be by about 2.5% annually for these currencies over the next 45 years. That's a pretty good tailwind alone, for investment results.

As the paper points out, things could obviously go wrong over that time period, but these results have reasonable potential to occur. Under the assumptions laid out in the paper (and with their model checked against history in other nations), it suggest that the largest economies in 2050 will be as follows:

1. China
2. US
3. India
4. Japan
5. Brazil
6. Russia

In other words, BRICs will have four of the top six spots. I think long-term investors should pay attention here, and try to understand why your particular investment advisor might be suggesting emerging market investment ratios of below 15% or 20% of your portfolio (which is actually below their current world GDP share in US$, at roughly 25%).

What also brought this issue into sharp relief for me, again, was a recent Economist magazine special on the world economy, that focussed on the emerging economies of the world. To an investor that wants growth at a reasonable price, these economies are growing their GDPs over the past five years at 5.6% annually, versus 1.9% for the developed world.

A forward-looking investor can't afford to ignore these reasonably-priced markets, and excellent growth prospects going forward. Are you such an investor?


JW

The Confused Capitalist