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Bubble fears overdone in emerging markets

IN SPITE of emerging markets’ strong rebound from the financial crisis and their rosy growth prospects, 41 per cent of European pension plans still have no exposure at all to this sector, according to an annual asset allocation report released earlier this month by Mercer, a consultancy.

But this is changing in the wake of the financial crisis – the Mercer report also reveals that many pension plans are now investigating ways to exploit the higher growth rates in emerging economies. In its World Economic Outlook, published last week, the International Monetary Fund forecasts that emerging markets will see GDP growth of more than 6.25 per cent this year compared to developed economies’ growth of 2.25 per cent.

While talk of overheating in China has dominated the headlines, flow data from EPFR Global showed that emerging-market equity funds have attracted the greatest net inflows in six months, receiving a combined $3.27bn in the week ending 7 April, taking year-to-date inflows to $10.8bn.

This suggests that the emerging markets story is far from finished for institutional investors – if you needed further evidence of the sector’s sustained popularity, you need look no further than J O Hambro Capital Management’s launch of a new global emerging markets equities fund yesterday. The Dublin-domiciled fund will be available to both retail and institutional investors and it has a capacity limit of $1.5bn.

The emerging markets story has two main threads: the shift towards domestic consumption and the unabated appetite for commodities.

The shift towards domestic consumption and away from export-driven demand will be exceptionally important given the sheer size of emerging markets in terms of percentage of world population – 58 per cent of the world’s people live in emerging markets today and this could grow to 69 per cent, says Julian Mayo, the co-chief investment officer of Charlemagne Capital, a specialist emerging market asset management firm that derives the majority of its business from institutional clients.

Andrew Beal, manager of the Henderson TR Pacific Investment Trust, says that the Chinese government is keen to encourage more discretionary spending. “To date, the model has been built on selling cheap goods to Americans but this is not going to get the region to the next level. They are desperate to build up domestic demand as domestic consumption needs will take up some of the slack.”

As far as commodity demand is concerned, Mayo thinks we haven’t seen anything yet. He points out that in terms of per capita copper consumption, China is only now where South Korea was in the late 1980s – at just 4kg per person per year – indicating that there is plenty more appetite for raw materials.

He also reckons that emerging market equities are looking cheap on a valuations basis. In spite of their recent outperformance they are still trading at discount to developed market equities. And if you look at the price to book versus return on equity relative to the world, emerging market equities are at a 62.5 per cent discount, the greatest since October 2002.

And if institutional investors are worried about a property bubble in China bursting, both Mayo and Beal think that at the moment there is little reason to be. At a national level housing affordability remains at a comfortable level historically and Mayo’s research shows that it has actually improved over the past year or so.

Emerging markets’ recognition of the need to reorientate towards domestic demand and their continued appetite for commodities should mean that the region remains attractive for many years yet.