On Emerging Markets

By Mark Mobius

We at Templeton Emerging Markets are celebrating our 20th anniversary this year. In 1987 we started our first Templeton Emerging Markets Fund, which, by the way, is still listed on the New York Stock Exchange. At that time our total assets under management were $100 million. It was a difficult time because in those days, although there were many emerging market countries in Asia, Africa, Latin America and Europe, very few of them were open for investment. There were strict foreign exchange controls, and limitations on foreign investment in addition to the plethora of problems of safekeeping of securities and market liquidity. So in that first fund we were able to invest in only five countries. Today we are managing $32 billion and we are invested in over 40 emerging market countries around the world. Most notable has been the opening of South Africa with the end of apartheid, the opening of Eastern European countries and Russia, and the opening of India and then, of course, China.

When people ask why emerging markets are important as an investment destination, I tell them that the reason can best be summarized in one word: growth. Emerging markets are growing at more than double the rate of the developed countries of the U.S., Japan, Western Europe, Australia, and New Zealand. Not only are emerging countries economic growth surging ahead, they are also becoming increasingly sophisticated and integrated into global markets. The emerging markets combined average annual GDP growth was 5.5% over the ten-year period ended 2005, which is more than double the 2.7% growth recorded by the developed countries during the same period. Economists expect this growth trend to continue for the foreseeable future. Furthermore, net direct investment inflows into emerging markets are expected to reach a record high level of $211 billion in 2007, following $185 billion in 2006. Key drivers included strong economic growth, robust corporate earnings, favorable financing conditions, and stock market appreciation—not to mention the interest rate spread on emerging markets bonds, which has fallen significantly in the last five years, from more than 1000 points to about 200 points today due to rising liquidity and low inflation.

They are defined as emerging markets on the basis of their average lower per capita income. However, while their per capita income is currently lower than that of developed countries, the growth rate at which emerging markets have been narrowing the gap will make them tomorrow’s developed markets. In the five year period between 2001 and 2005, per capita income in developed markets grew by 25%, while in emerging markets it grew by 50%. This growth is expected to continue and even accelerate as more and more emerging countries enter the “take-off” stage of sustained economic development.

Of course, stock markets reflect the economic health and growth of countries, and this is certainly true of emerging countries. In fact, of the 26 countries in the MSCI Emerging Markets index, 18 of them reached record levels in 2006 or thus far in 2007. Strong investor confidence, continuing fund inflows, and a cultivating macroeconomic environment contributed to the strong performance. Portfolio fund flows into emerging markets totaled $24.6 billion in 2006, the highest in more than ten years, and nearly 50% more than the $16.9 billion in 2005. The index has also expanded to include 26 countries from its origin in late 1987, when it covered just 10 markets. The market capitalization of the index has also grown significantly, from $35 million to $2.4 trillion.

In a bull market that has run for nearly four years with few interruptions, corrections such as those in May 2006 and February 2007 can be expected, and are in fact healthy. After the decline in May 2006, markets rebounded and reached new highs.

Within the emerging markets realm, Eastern Europe in particular has undergone significant developments. A major event was the accession of 10 additional countries into the European Union (EU), which expanded the trade bloc to 25 members in May 2004; the addition of Bulgaria and Romania this year has brought the total number to 27. Improved corporate governance, robust earnings growth, consolidation and M&A activities in the region as a result of EU convergence, a reduction in sovereign risk, and a stronger macroeconomic environment have all contributed to the stock price appreciation and the re-rating of Eastern European equities over the last five years. While the correction in oil prices from the high in 2006 has impacted oil-exporting markets such as Russia, we expect oil prices to remain firm because of geopolitical and bottleneck problems. The 12 Eastern European markets which gained entry into the EU in 2004 and 2007 are expected to continue to benefit from EU convergence, access to funds, relatively lower labor costs, business-friendly tax laws, cost competitiveness, higher GDP growth, and foreign direct investment inflows.

The growth prospects for Latin America continue to be good. Strong commodities prices associated with a solid domestic demand for goods and services are the key drivers of such a boom in the respective economies. The number of stock and bond offerings is an important thermometer of the confidence of investors in the region. Despite the May-June correction, the performance of the Latin American stock markets has been strong. Supporting the region’s growth, politically, we expect to see a smooth transition of power resulting from elections in the region. Brazil, Chile, Colombia, Peru, and Mexico have already held elections. Argentina is also likely to have no major volatility in the stock market because of the new government that will be inaugurated next year.

Generally, much focus has been on Brazil, the region's largest investible market. The Brazilian economy has recorded a strong current account surplus, which is supported by a record trade surplus due to high volume and price exports of commodities. International confidence has also been high, with the interest rate spread on emerging markets bonds at a record low. Moreover, the economy has solid fundamentals and decreasing external vulnerability supported by an increasing foreign reserve. Expectations are that Brazil will attain an investment grade rating in the coming years. In Mexico, economic growth has been robust, with forecasts upgraded. The country has benefited from the high oil price environment, a good performance of the neighboring U.S. economy, and generally strong domestic demand in election years.

The role of Asian markets in the global economy has grown significantly in recent years, and we expect this trend to continue in the future. While Asian companies have recorded significant price appreciation, corporate earnings have also increased, making valuations still attractive. The opportunities are plentiful, with market fundamentals supporting the long-term uptrend of these markets. Many companies are experiencing strong growth and there are many upcoming IPOs in many markets. The key is to find undervalued companies that are well capitalized and have a unique and competitive product range. Companies that are paying solid and sustainable dividends are especially attractive.

We believe all kinds of stocks in Asia offer opportunities for the next 10 years. The reasons for this are clear: Asian countries are growing very fast. They include countries like China and India, with very large populations whose per capita income is growing, and capital markets in those countries are now undergoing rapid development. Economic growth continues to be strong in many Asian countries, per capita incomes have been rising, valuations remain attractive, and reforms continue, thus improving the region’s business and investment environment. Also, Asian countries increasingly are not only dealing with developed markets such as the U.S., but also with each other, and thus the dependence on the U.S. is lower now. For example, Taiwan and South Korea are now exporting more to China than to the U.S. This trend is expected to continue.

On the African continent, companies are rich in commodities and minerals, which are essential to the global economy, and thus these companies continue to perform well. In South Africa in particular, the good corporate governance standards exhibited by local companies, sound regulatory structures, and efforts to expand their international market share, as well as capable management teams, can assure investors of finding investment bargains. A consumer boom, propelled by credit growth and higher disposable income, as well as strong finance, manufacturing, business, and construction sectors has led South Africa’s economic growth. The hosting of the 2010 soccer World Cup means that we can expect to see significant spending on infrastructure, which will continue to support the country’s growth.

For some time, we have been emphasizing four major themes in our investments that we call the “four Cs:” Consumer, Commodities, Convergence, and Corporate Governance: Sectors that are geared towards direct consumption will continue to benefit from the higher disposable income per capita in emerging markets. With commodity prices at relatively high levels, there will be many opportunities for good profits for companies supplying them. Convergence between Asia and China will continue to provide good opportunities for companies. Finally, Corporate Governance is very important in investing. We want to invest in companies that treat investors fairly.

Currently, one of the biggest risks for emerging markets is a sharp deceleration in economic growth in the U.S. Another worry is oil prices. The conflict in the Middle East, which produces nearly a third of the world’s oil, has fueled concerns of interruptions to supply which, if realized, could impact the world economy. Tightening global liquidity could also hinder the performance of these markets. Ample liquidity has been a major driving force of the strong market performances we have seen in emerging markets. There could be a liquidity problem if the U.S. Federal Reserve decides to raise interest rates aggressively, although its decision to keep interest rates unchanged since August has provided investors with comfort. Any interest rate increases by the Bank of Japan and strengthening in the Yen could also have an impact.

Furthermore, no one can predict the market direction, and a bear market could start at any time. However, the good news is that bear markets are shorter in duration than bull markets, and bear markets go down a smaller percentage than bull market increases. Global economic conditions are positive and countries have made substantial strides in reforming their economies.

Stock markets in emerging markets are in good shape and reasonably priced. Although share prices have increased strongly in recent years, so have earnings. This means that price/earnings ratios remain reasonable. Even from a fundamental point of view, emerging market economies look strong. Inflation in emerging markets is relatively weak and growth is strong. Governments are solvent and not many of these countries are reliant on foreign money to finance their investment needs.

Moreover, emerging markets continue to report strong macroeconomic growth and are implementing structural reforms. Taking a long-term view, emerging markets continue to offer investors with an attractive investment destination. The role of emerging markets in the global economy has grown significantly in recent years. These countries have made fundamental improvements to their economies and these changes are here to stay. These developments mean that emerging markets investments contain good opportunities. In addition to the traditional emerging markets, the larger frontier markets such as Slovenia, Romania, Ukraine, Vietnam, and Dubai are also beginning to look interesting.

In general, the strong fundamental outlook for emerging markets remains intact. Investors should expect volatility as part of the nature of these markets, but we expect long-term investors to be well rewarded.

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